Understanding How a Term Deposit Works

A term deposit is a deposit account held at a financial institution. The money is locked up for a specific period in exchange for an interest rate.

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Term Deposits Explained

One of the ways banks and credit unions make money is by using customers’ deposits to lend money to borrowers. In return, banks pay interest on deposit accounts, such as checking and savings. However, money in these accounts can be unpredictable because they are highly liquid. To make their balance sheets more predictable, banks and credit unions offer term deposit accounts to customers.

Term deposit accounts pay customers a higher rate of interest than checking and savings accounts. In return, customers must keep their money in the account for a set length of time. If the customer wants to withdraw their money early, they often cannot do so without a penalty. They may also have to give advanced notice before ending a term early.

How Do Term Deposits Work?

Term deposits are deposit accounts usually held at a bank or a credit union. Money in a term deposit account must stay put until the end of the term. In return, they pay an interest rate higher than rates on checking and savings accounts. One of the most common types of term deposits is a certificate of deposit (CD). If you put money into a term deposit at a bank, it will be insured by the Federal Deposit Insurance Corporation (FDIC). The National Credit Union Association (NCUA) ensures those at credit unions.

The money in a term deposit account must remain until the end of the term. It may be accessible sooner, but there is usually an early withdrawal penalty if a customer accesses their funds before the end of the term. For instance, they may have to forfeit any interest they’ve received on the account.

Many term deposit accounts also have a minimum deposit; for example, it might require a minimum deposit of at least $1,000 to get started. Others don’t have a minimum investment but likely pay more interest for larger deposits.

Term Deposit Rates

Term deposits pay varying interest rates depending on the size of the deposit and the length of the term. For instance, large deposit sizes and longer terms pay slightly higher rates of interest to compensate customers.

Here’s an example of a term deposit rate table from CommBank in Australia:

Term Deposit Risk

While term deposits are relatively safe investments, two kinds of risk may impact them: interest rate risk and inflation risk. If interest rates fall, saving becomes less attractive, and borrowing becomes more attractive. The longer the term, the greater the chance interest rates will fall at some point before the end of the term. If an investor’s money is locked up in a term deposit when rates are falling, there will be an opportunity cost of having that money unavailable for other uses.

There is also inflation risk. Although term deposits pay higher interest rates than checking and savings accounts, they typically don’t pay enough to keep pace with inflation. Thus, money in a term deposit account may have less purchasing power than it did at the beginning of the term, even after interest is paid on the account.

Laddering Investments to Reduce Risk

One strategy some term deposit investors use to reduce inflation and interest rate risks is to ladder their investments using term deposits of varying lengths. For example, an investor might buy a six-month CD, a one-year CD, a two-year CD, and a three-year CD. This is a way of diversifying their investment to lessen their interest rate risk. When the first CD ends, they can roll it into a new CD to continue their investment. Alternatively, they can use the money as income if necessary.

Bottom Line

Term deposits typically pay investors a higher rate than checking and savings accounts. In return, investors must keep their money in the account for a set length of time. One of the most common types of term deposit account are CDs. Term deposits pay higher rates for longer terms and larger deposits. These accounts are insured by the FDIC or NCUA but are not risk-free. Inflation and interest rate risk are among the risks that can affect term deposits. Some investors use laddering strategies to lessen these potential risks’ impact.

Tips for Saving

• A financial advisor can help you work through your banking needs and put together a plan that works in your unique situation. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• Term deposit accounts such as CDs usually pay higher interest rates than checking and savings accounts. But that doesn’t mean all CDs pay great rates. Some also have high minimum investments. Check SmartAsset’s list of the best CD rates to be sure you are making the most of your money.

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