What is a CD?

I went to a mentalist/magician performance last week, and I am forever changed. I know there is a trick I don’t understand. I know there is an extreme art and performance to what he does. Having said that, I believe in magic now because nothing else makes sense.

A Certificate of Deposit (CD) is essentially a loan from you to the bank for a fixed period of time at a fixed interest rate. From 3 months to 10 years, CDs are offered at nearly every time interval with interest rates that beat the standard savings account.

You receive a higher interest rate but the bank charges you a penalty if you withdraw money from a CD earlier than agreed upon. CDs are great options for anyone with savings set aside for a known future purchase. If you’re buying a house/car or going on a vacation, you can put your savings into a CD to earn a higher guaranteed rate until you plan to make the purchase.

You can also use money market or bond funds for that cash, but CD interest rates may beat money market funds. Depending on the needs of the bank, they may be trying to attract more funds with higher CD interest rates. Before hitting the easy button with a money market fund, you should check out CD rates. Your bank may offer shockingly high rates!

So why would a bank offer this?

I know it might be hard to believe, but when you deposit money in a bank, it does not sit in a vault waiting for you to come back. 

In fact, your bank is taking your money and loaning it out to make money with your money. They may loan out your money making the bank 8% interest but only pay you 0.05%. WHAT A RIP OFF! Well… the bank is doing all the due diligence, collections, and still owes you regardless if they get paid back for the loan. However, the interest on a standard savings/checking account is still atrocious.

Banks play a fun little game of “how much can I loan out while still operating our ATMs?” The goal is to loan out as much money as possible while still meeting the expected withdrawal requests. 

Following 2008, the US government instituted a series of serious regulations that require specific liquidity coverage ratios and capital adequacy ratios aimed at ensuring banks can meet obligations even in periods of economic turmoil. While cumbersome, these regulations help build confidence in our financial institutions and keep the ATMs flowing.

Your money sitting in a checking account is a “demand deposit” on the bank's books. This means it counts against their reserve requirements. They must maintain enough liquid assets to stay at the 10% capital adequacy ratio. 

Your money sitting in a CD is a “time deposit” and subject to different regulations. Your bank can assume you’ll withdraw your money at the end of the CD. While your money sits in the CD, they can lower their liquid reserves (i.e. loan more money and make more money). Your $2,500 CD isn’t making a difference for Bank of America’s bottom line, but if 10,000 people open CDs, that is a meaningful difference.

A CD is a way for banks to loan more money and for you to earn more interest. It is a rare win - win. Ignore the fact that it’s only a win for you because the bar set by the very same banks is so low in a standard checking account… It’s all about framing.

CDs are a great way to lock in higher interest rates with no risk since they are still protected by the FDIC. They may make a great addition to your financial plan!

Debrief on Deck

Next week, we are going to talk about mortgages AGAIN. What is a FHA, VA, USDA, ARM, interest-only, FDA, JRTC, MCCC, or YDDR loan?? So many options! Let’s get into some acronyms.

I may have made up a few for comedic effect.

As always, please reach out to us with any questions or comments you have. You can reply directly to this email or find us on Instagram.

Until then, stay the course.

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