What Is a Term Deposit?
Term deposits will usually have short-term maturities that can range from a few months to a few years. The required minimum deposits for such instruments will also vary based on the size of deposit, term, and rate of interest.
How Does a Term Deposit Work?
The customer will purchase the term deposit at the bank for a specified maturity at a stated rate of interest. The investor commits to not withdrawing the funds until maturity, and in return, the bank pays a higher rate of interest on a term deposit than it would on a simple savings account. The interest rate depends on the length of the term and the amount deposited.
For a deposit with a longer term, the bank will offer a higher interest rate. Also, banks pay higher interest rates for larger amounts deposited. The interest may be paid, depending on the term, at maturity, quarterly, or monthly.
The customer can choose to receive the interest payments or let them accumulate in the account. The bank will likely charge a penalty for early withdrawal of funds, which may include a forfeiture of interest payments, though there are some no-penalty CDs available.
How a Bank Uses Term Deposits
Banks are required to maintain a certain reserve in cash to meet current obligations. As such, the bank invests the funds in a higher yielding investment or lends them out at a higher rate than it is paying the depositor. The spread between what the bank is paying to the term deposit customer and the rate it is earning on the higher yielding investment or loan is known as the net interest margin.
Advantages and Disadvantages of Term Deposits
Term deposits appeal to conservative investors for several reasons:
- Term deposits pay a much higher rate of interest than standard savings or checking accounts.
- While term deposits have a stated maturity length, they are considered short term and thus less susceptible to longer-term interest rate changes and inflation.
- The funds are insured, up to the stated amount per depositor, per account, by either the Federal Deposit Insurance Corporation (FDIC) or the National Credit Union Association (NCUA).
When a term deposit such as a CD approaches maturity, the institution notifies the investor. Often, the bank or credit union will offer the investor the opportunity to renew or rollover the term deposit for either the same term or a different term depending on the products that are available. The interest rate may change depending on where interest rates are at that particular time.
There are, however, some disadvantages to term deposits. Term deposits are largely immune to market risk and are generally considered liquid, though a depositor will typically pay a penalty or forfeit interest earned for withdrawing the funds prior to the stated maturity.
Another obvious disadvantage is the lower rate of return. While term deposits are considered an ultra-safe investment and ideal for short term savings goals, they are not well suited for long term investment or retirement planning. Long-term investing requires a higher rate of return to keep up with or outpace the rate of inflation. In the current interest rate environment, a term deposit investment cannot meet that need.
Term Deposits and Interest Rates
Typically, when interest rates are rising, depositors will find term deposits more attractive as savings rates are higher. Borrowing money is less attractive when rates are higher, and banks can inversely use higher interest rates as a tool to further encourage saving.
Conversely, when interest rates are lower, borrowing rates are more attractive than savings rates. Therefore, it is more difficult for banks to attract depositors in this environment.