Safe and Simple Investing with Term Deposits
Imagine taking a handful of cash, digging a small hole in your backyard, and planting that cash in the ground. You pat the soil with your shovel. Wipe the sweat from your forehead. Sure, it may seem a little insane. Maybe the neighbours start talking, but it doesn’t faze you. You’re finally doing it. You’re investing!
You water your lump of soil regularly, kick back with tall glass of lemonade, and wait for the sunshine to do its work. Over a certain period of time, maybe a few weeks, you notice a nice little sprout poking up thorough the soil. You try to forget about it and go about your life, until one day a few years down the road you walk outside and you realize that your little money seed has turned into a full-grown money tree. You look up at the glorious leaves of your beautiful Canadian currency rustling in the summer breeze, the sun reflecting off of the synthetic polymer as you reach up to collect your money. Your investment has matured, and you’ve successfully reached your investment goals. You did it!
Ahem. That’s not the way this works.
(Insert the haunting echo of your father telling you that money doesn’t grow on trees.)
It’s true. Stuffing your money into the ground isn’t the best way to invest. The five-year old version of myself can attest to that. But the metaphor works quite well here as we explore one of our safer investment options: the term deposit.
What Is a Term Deposit and How Does It Work?
So, what is a term deposit? How does it work? And why is it considered such a safe investment for many Canadians that are cautious about investing and looking for a risk-free way to reach their financial goals? Let’s tackle each of these separately.
A term deposit is an investment product. It’s a deposit account at a financial institution that typically comes with a short-term maturity date—meaning that it matures (or is finished growing) in anywhere from one month to three years. But there are also term deposit products that come with longer terms, including deposits with five-year and even 10-year maturities.
Term deposits with longer terms are sometimes called guaranteed investment certificates (or GICs).
When purchasing a term deposit, an investor has two primary considerations: the interest rate and the term. A term deposit with a longer term (or length of time) will almost always yield a larger interest rate. When a term deposit reaches maturity, the initial investment is paid back to the investor, along with the interest the investment has made over the term.
How Is Interest Calculated on Term Deposits?
So, now that we know a term deposit is an investment product with an interest rate and a term, are there any other considerations? Well, I’m glad you asked! One other important consideration is how the interest rate is calculated.
There are a few different ways interest is calculated on term deposits, so it’s important for investors to understand this calculation in order to understand what return they’ll see when their investment matures.
For fixed-rate term deposits, the calculation can be quite simple. Let’s use an example. Say you have a $10,000 one-year, fixed-rate term deposit with an interest rate of 2%. Here’s how you would calculate your return: initial investment x interest rate = return on investment. In this example, your return on investment would be $200 ($10,000 x 0.02 = $200).
Of course, things can get a little more complicated. Our example only works if interest is calculated yearly on a fixed rate term deposit. But banks can be creative, too! (In a math professor kind of way.) Many banks offer different kinds of term deposits and different ways to calculate interest rate frequency—including a little something called compound interest.
Though we won’t go into detail, here are different kinds of term deposit options you might find out in the banking wild:
- Fixed-Rate GICs
- Variable-Rate GICs
- Step-Rate GICs
- Adjustable Rate GICs
- Cashable GICs
- Redeemable GICs
- Non-Redeemable GICs
- Registered GICs
- Foreign GICs
How Does a Term Deposit Make Money and How Does It Benefit Banks?
So, you put your money in a term deposit, and 5 years later you have your money back plus interest. How can that be? How did that just happen? you ask. Are the banks just taking your money and planting in the ground? (You really need to let that go—no one is planting money in the ground.)
Here’s how term deposits benefit banks.
All that money banks raise in term deposits is used to fund loans and mortgages and other lending products. Bank raise money at a lower interest rate using term deposits and lend it out at a slightly higher interest rate in the form of mortgages or loans. The difference in the amount raised and the amount banks charge is what generates revenue. This difference in interest is called a bank’s spread.
Why Are Term Deposits a Safe Investment Option?
Term deposits really are one of the safer options for conservative Canadian investors. That’s because there’s little to no risk of losing your initial investment and you’re guaranteed a return. They’re also insured by the CDIC. They’re very much like a stripped-down savings account, but one with a slightly higher interest rate and a term.
A term deposit may not be the best option for every investor. But it’s a safe option for an investor interested in a low risk investment option. No matter what kind of investor you are, please put that shovel down. And if it’s too late, maybe go dig up that money.
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