What is a Time Deposit?
Time deposits are savings accounts at a bank where the funds are unavailable for withdrawal for a predetermined period of time. In exchange for the lack of liquidity, banks offer a higher yield on time deposits than they offer on regular savings accounts. The most common type of time deposit in the United States is the Certificate of Deposit, or CD. Certificates of Deposit are offered in any amount and in terms ranging from one month to several years. The longer the term and the higher the deposit amount, the greater the annual yield.
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Function
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Banks are in the business of lending money. In order to do that, they need to receive customer deposits. Once they have customer deposits, they can lend that money to other customers. However, demand deposits like checking accounts and savings accounts can't be used to loan money to other customers because the original account holder can demand the money back at any time. So the bank pays higher interest to entice customers to establish time deposits. For example, if a bank offers a customer a five-year CD paying three percent interest and the customer agrees to deposit the money, the bank can then loan that money to another customer for four years at eight percent interest and make a profit.
Types
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There are two types of Certificates of Deposit: regular and jumbo. To qualify for jumbo CD rates, a bank customer must open a CD account with $100,000 or more. Obviously, jumbo CD rates are higher than regular CD rates. After the market crash of 2008, FDIC insurance limits were raised from $100,000 to $250,000. Investors otherwise reluctant to deposit an amount so close to the insurance limit are now able to do so with the peace of mind that their investment is insured.
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Time Frame
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The beauty of a time deposit is that the bank customer can choose how long he wants to keep his funds on deposit. CD terms begin at one month and go all the way out to five years. There are interest penalties involved in cashing in a CD before its maturity, but the principal amount invested can never be penalized.
Potential
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Due to their insured status and non-existent risk, time deposits have fairly limited growth potential. Annual yields on time deposits closely mirror inflation rates historically. Time deposits, while perhaps the safest investment available, are not ideal for long term growth strategies.
Expert Insight
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There is a popular technique for investing in time deposits called "laddering." This is a method of dividing available funds among several different terms of CD rather than investing the entire amount in one CD. By staggering the maturity dates of several CDs, when one CD matures an investor has the opportunity to make more money if yields have increased or to remain in cash until yields do increase.
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