Definition of Certificate of Deposit
A certificate of deposit, also referred to as a CD, is a time deposit at a bank, credit union, or other financial institution. A certificate of deposit requires that the money cannot be accessed until an agreed upon maturity date. However, if the depositor insists on withdrawing the money before the maturity date, the financial institution will assess a penalty—usually the loss of interest.
Since the depositor agreed to a maturity date, the certificate of deposit will pay a higher interest rate than is paid on a regular savings account or money market account. The length of a certificate of deposit will vary. It could be for one month, three months, six months, one year, 17 months, three years, etc. Generally the longer the time until maturity, the higher the interest rate.
A CD that matures in less than one year will be reported by the bank as a current liability, and will be reported as a short-term investment by the depositor (provided the amount is not restricted by the depositor).
Example of a Certificate of Deposit
James Company has a seasonal business and wants to earn interest on its excess cash balance during the seven months between its busy seasons. Therefore, James Company purchased a six-month certificate of deposit for $100,000 from its local bank. The CD pays an annual rate of 1% compared to 0.4% of the bank's money market account, 0.1% on the bank's savings account, and 0% on the bank's checking account.