There are many forms of money kept in bank accounts, including checking and savings, money market accounts and certificates of deposit. While the first three are highly liquid, meaning there are few requirements on when the money can be withdrawn, CDs have a specific term. Deposits whose term is longer than a year are considered long-term.
Lengths of CD terms
Banks offer numerous kinds of certificates of deposit to customers, generally ranging in maturity from three months to five years. During the term of the CD, the bank pays the depositor a set interest rate, usually monthly or quarterly. At the end of the term (the maturity date), the bank either pays back the customer's principal or rolls it over into a new CD.
Why customers like long-term deposits
Customers choose long-term deposits of one or more years in order to gain a better interest rate. Generally the longer the money is locked up, the better the interest rate the bank must pay for the privilege of holding that money. When interest rates are low, short-term deposits sometimes yield close to nothing, especially when inflation is taken into consideration. Hence customers who don't need the money in the present might agree to lock it up for a long-term period in exchange for a better yield.
Why banks like long-term deposits
Deposits are a bank's chief funding source. They lend out the deposits to customers in the form of mortgages, lines of credit and other types of loans. Banking regulations establish how much in loans banks can have in relation to deposits. Banks make their money through the spread between what it costs them to pay depositors and the interest payments they take in from loans. Long-term deposits offer a stable funding source for banks, while money in short-term deposits and checking accounts is too liquid to rely on as a source for lending.
Video of the Day
Disadvantages to long-term deposits
Customers are assessed penalties if they withdraw money from CDs before the term is up. Thus, long-term deposits give customers less financial flexibility. Also, if inflation heats up during the CD's term, the locked-up money's purchasing power is sapped. There are also downsides to long-term deposits for banks. They must pay a higher interest rate than on short-term deposits, and if interest rates fall during the term they're stuck paying out above-market rates.
Alternatives to long-term deposits
When interest rates are low and inflation risks can be seen, even long-term deposits may not pay out enough interest to make them worth a customer's while. In this case customers may consider taking on extra risk in exchange for better yield with assets such as annuities, long-term Treasury bonds or dividend-paying stocks. Banks who need the deposits to be able to lend might be forced to raise rates on long-term deposits to keep their customers.