Time Deposit (aka Term Deposit) Definition and How Does It Work?

What Is a Time Deposit?

A time deposit is an interest-bearing bank account that has a pre-set date of maturity. A certificate of deposit (CD) is the best-known example. The money must remain in the account for the fixed term in order to earn the stated interest rate.

Time deposits generally pay a slightly higher rate of interest than a regular savings account. The longer the time to maturity, the higher the interest payment will be.

Another name for this type of investment is term deposit.

Time Deposits Explained

A time deposit such as a CD can be purchased at virtually any bank, credit union, or other financial institution. The interest rates paid vary, as do other terms. For example, one bank may offer a higher return but require a larger deposit.

It pays to shop around. Most post their rates prominently and advertise them widely.

A CD is essentially a savings account that is opened with the promise that the owner won't touch the money for a set period of time. This can range from a few months to years. A term of a year or less is considered a short-term time deposit. Anything over that is a long-term deposit.

Penalties on Early Withdrawals

The owner of a time deposit can withdraw the money out if necessary but will lose some or all of the promised interest and may pay penalty fees. The terms are in the fine print that the saver receives when opening the account.

A customer can earn a slightly higher interest rate with a time deposit account than would be available in a standard savings account or an interest-bearing checking account. The better return is offered because the funds remain locked until the maturity date of the account.

Time deposits are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per investment. Those opened at a credit union carry protection from the National Credit Union Administration (NCUA).

Why Banks Offer Time Deposit Accounts

Time deposit accounts provide banks with the cash flow they need to lend money to other customers. The bank makes a profit by lending the funds held in time deposit accounts for a higher interest rate than the rate it pays on the time deposits.

The bank may also invest the money from the time deposit in other securities that pay a higher return than it is paying the customer.

Some Options on Time Deposits

Banks and other financial institutions may accept any maturity term that a customer requests, as long as it is a minimum of 30 days.

Once the investment matures, the funds can be withdrawn without penalty. Or, the investor may choose to renew the time deposit account for another term. For example, a one-year CD could be rolled over into another one-year CD.

Longer Terms Earn Higher Interest

Typically, the longer the term to maturity, the higher the interest rate paid to the depositor. For example, a one-year CD may offer a 1.10% annual percentage yield (APY), while a five-year CD for the same amount might provide a 1.75% APY. The annual percentage yield is the effective annual rate of return (RoR) taking into account the effect of compounding interest. 

Generally, two rates are quoted for time deposits and CDs:

• The interest rate is the percentage interest that the customer would earn if the customer withdrew the interest amount received each month.
• The annual percentage yield (APY) is the amount that the customer will earn if the interest is allowed to remain in the account and compound.

The APY is, therefore, higher than the quoted interest rate.

The Downside of Time Deposits

As with most financial products, there are advantages and disadvantages to time deposit accounts. Above all, they are a safe place to put your money and they're a breeze to obtain.

On the other hand, the rate of return is usually lower than that for other investments. The investor could deposit the same amount of money in a bond mutual fund or Treasury bills and earn a higher yield.

There is another risk, especially if the investor chooses a long term for the time deposit. Interest rates may go up over time, while the investor's money is locked into the rate that prevailed when the account was open.

Higher interest rates go hand in hand with higher inflation. So, that investor's money is shrinking while it sits there, in terms of real spending power.

Real-World Examples of Time Deposits

A look at some examples of time deposit returns as of Feb. 9, 2020, offers some insight into the variations among CDs on offer at financial institutions.

• American Express advertised CDs with an APY of 0.55% for one year, 2.05% for three years, or 2.15% for five years. There was no minimum deposit.
• Comenity Direct rates were 2.10% APY for one year, 2.20% for three years, and 2.20% for five years. There was a minimum $1,500 deposit.
• Synchrony Bank rates were 2.00% APY for one year, 2.10% for three years, and 2.15% for five years. There was a minimum deposit of $2,000.