How do CDs work? A quick 101 Guide
A bank CD is an acronym for certificate of deposit.
Unlike traditional savings accounts, CDs typically offer higher interest rates, making them an attractive option for those looking to grow their savings with minimal risk. When you open a CD, you agree to keep your money in the account for a specific term, which can range from a few months to several years. In exchange for this commitment, you benefit from a guaranteed interest rate, making CDs a predictable and secure way to save. Banks and credit unions both offer CDs, and opening a CD is a straightforward process that can help you reach your financial goals.
How CDs work
CDs work by locking in your money for a fixed period, known as the term length, with a guaranteed fixed interest rate. When you deposit funds into a CD account at a bank or credit union, you agree not to withdraw the money until the CD matures at the end of the term. During this time, your deposit earns interest at a rate that is usually higher than what you’d get from a regular savings account. Term lengths can vary, so you can choose a CD that matches your savings timeline—whether that’s a few months or several years. Once the CD matures, you can withdraw your original deposit plus all the interest earned, or you can roll it over into a new CD. However, if you need to access your money before the CD matures, you’ll likely face early withdrawal penalties, which can reduce the interest you’ve earned or even affect your principal in some cases. Understanding how CDs work can help you make the most of this savings tool while avoiding unnecessary fees.
Purchasing a CD
Opening or buying a CD is as simple as visiting the bank, either in person or online. Obtaining a CD is as simple as:
- Choosing the CD terms that are right for you
- Reading and signing the enrollment agreement
- Transferring or depositing funds to the CD
When opening a CD, you will typically need to meet a minimum opening deposit. The minimum deposit required or minimum deposit amount can vary depending on the institution and the type of CD. Some CDs, such as jumbo CDs, require a much higher minimum deposit, often $50,000 or more, and may offer higher interest rates. Not all CDs have the same features—there are options like no-penalty CDs and step-up CDs, and both bank CDs and credit unions offer CDs with different terms and requirements.
Other than the type and term of CD, the most important decision you have to make is what you want done with the interest your CD earns. In most cases you have three choices:
- Receive a check
- Have it transferred to your savings or checking account
- Reinvest it
Banks use the term rollover to talk about reinvesting your original investment and earned interest when the CD matures.
For example, if you purchased a $1,000 CD and it earned $20 in interest and you choose to roll it over, you would have a new CD worth $1,020.
You can usually make the decision to roll over your CD at any time before it reaches maturity.
An advantage of a rollover is that you won’t have to complete another set of paperwork for the new CD.
CD benefits
Even though CDs are not glamorous or exciting investments, they do have some important benefits.
- Safe and secure – CDs offer strong safety benefits because they are fully insured for up to $250,000 per depositor, per institution by the FDIC or NCUA. Unlike investments such as stocks or bonds, certificates of deposit do not carry market risk, making them one of the safest options available.
- Better return – CDs pay a higher interest rate than ordinary savings accounts, and the annual percentage yield (APY) is a key metric for comparing CD returns. Accrued interest and regular interest payments are important benefits that help your savings grow over time.
- Flexibility – Most CDs offer fixed rates and a fixed term, allowing you to choose from a variety of terms (length of commitment), rollover choices, and predictable savings with certificates of deposit.
- Short-term investments – CDs are an ideal place to stash cash for your emergency fund or as part of your retirement plan. However, compared to a money market account or a high-yield savings account, CDs typically offer higher returns but less liquidity, so consider your need for quick access to funds when choosing between these options.
Safety and security
One of the biggest advantages of a certificate of deposit is its safety. CDs are insured by the Federal Deposit Insurance Corporation (FDIC) if you open them at a bank, or by the National Credit Union Administration (NCUA) if you use a credit union. This federal insurance protects your deposit up to $250,000 per institution, so you can rest easy knowing your money is secure even if the financial institution fails. Because CDs are not tied to the ups and downs of the stock market, they are considered a low-risk way to earn interest on your savings. When your CD matures, you’re guaranteed to get back your initial deposit plus any interest earned, making CDs a reliable choice for conservative savers.
Choosing the right CD
There is no such thing as the best CD for everyone. There are only the best CDs for you and your needs.
Choosing the right CD means matching your goals with the right combination of terms and type of CD. CDs have a fixed term, which means the length of time your money is locked in is predetermined and predictable.
Goals for your investment
Before you can choose the right certificate of deposit, you have to define your goals. Often, the best way to do this is by asking yourself questions, and two important questions are:
- Do you anticipate needing the money in the short or long term?
- What is more important, interest rate or liquidity?
CD terms
The length of time a CD takes to mature (earn all of its interest) can be anywhere from three months to three years. The maturity date is when the CD's term ends and you can access your funds, decide whether to renew, or reinvest your money.
As a rule, the longer the term of the CD, the higher the interest rate it will pay.
The best way to choose the term of a CD that is right for you is to have an idea of how soon you will need access to your money.
This is important because banks will charge you an early withdrawal penalty if you need to access your money early, before the CD matures.
The amount of the penalty is a percentage of the interest the CD is expected to earn.
In some cases, banks will take a portion of your principal (the money you put in) if the CD did not earn enough interest to cover the penalty.
Common types of CDs
Just like CDs come in a range of terms, there are different types of CDs. There are also different types of CD accounts, including bank CDs, which are purchased directly from a bank, and brokered CDs, which are bought through brokerages and can be traded on the secondary market.
Some common types include:
- Traditional CDs: Fixed interest rate and term
- No-penalty CDs: Allow early withdrawal without penalty
- Jumbo CDs: Require a higher minimum deposit
- Step up CDs: Feature automatic interest rate increases at set intervals, letting you benefit from rising rates
- Bump up CDs: Allow you to request a higher rate if market rates go up after you open the account.
CDs also come in various term lengths. Long-term CDs, which have longer maturity periods, can be a good option for maximizing returns if you don't need immediate access to your funds.
Traditional CDs and their fixed interest rate
These are sometimes called fixed-interest CDs because they pay a fixed interest rate over the CD term. A traditional CD is the standard, fixed-term certificate of deposit with a fixed interest rate.
Fixed-rate or traditional CDs are by far the most popular type of CD because customers know exactly what to expect.
Variable CDs
The interest rate that these CDs earn can change over time, which is what makes them variable.
The interest rates on these CDs are tied to a particular benchmark, such as U.S. Treasury Bills.
When the rates on these go up or down, so does the interest rate on the variable CD.
Liquid CDs
These CDs usually come with a higher minimum purchase amount than other CDs, typically $3,000-$5,000.
They are considered liquid because they allow owners to withdraw a percentage of their investment early without penalty.
Other conditions may include a minimum balance requirement.
In exchange for liquidity, these CDs may offer a lower interest rate than comparable traditional CDs.
IRA CDs
Similar to other retirement accounts, the interest earned by these CDs accumulates on a tax-deferred basis.
That means that you will not have to pay income taxes on the interest until you retire.
The advantage of this is that your income, and therefore your income tax rate, will be lower when you retire, saving you money.
These CDs usually prohibit you from withdrawing money until you are 59 ½ years old.
Early withdrawals would be subject to income tax and a 10% penalty.
Current CD rates
Interest rates
CD interest rates are set by the bank or credit union and remain fixed for the entire term of your deposit, giving you a predictable return. Generally, the longer the CD term, the higher the interest rate you can earn, as you’re committing your money for a greater period. CD interest rates can vary based on market conditions, so it’s important to compare rates and consider your financial goals before choosing a CD. Some CDs, like bump-up CDs, offer the flexibility to increase your rate if interest rates rise during your term.
Taxes and penalties
When you earn interest on a CD, that interest is considered taxable income, and you’ll need to report it on your tax return each year. Your bank or credit union will send you a 1099-INT form detailing the interest earned. It’s also important to be aware of early withdrawal penalties, which are fees charged if you take money out of your CD before it matures. These penalties can range from a few months’ worth of interest to even more, depending on the terms of your CD. Early withdrawal penalties are designed to encourage you to keep your money in the CD for the full term, so always review the terms and conditions before opening a CD account.
What does it mean to ladder a CD?
Many people appreciate CDs for their security and attractive interest rates. However, some are hesitant because CDs lock up their money for a set period. If that sounds like you, CD laddering might be the perfect solution.
CD laddering combines the benefits of higher interest rates from longer-term CDs with the flexibility of easier access to your funds from shorter-term CDs. By purchasing multiple CDs with staggered maturity dates, you can enjoy both better returns and regular access to your money.
This strategy allows you to build a portfolio of CDs that mature at different times, giving you the best of both worlds: the higher yields of long-term CDs and the liquidity of short-term CDs. With a CD ladder, you’ll have more frequent opportunities to access your funds without sacrificing potential earnings.
CD ladder strategies
A popular strategy to organize your CDs is to create a flexible CD ladder. This approach allocates your money across multiple CDs, allowing you to enjoy a steady stream of income while maximizing your interest earnings.
For example, if you have $10,000 to invest in CDs and want a regular source of annual income, you could purchase five $2,000 CDs.
Each of these five CDs would have staggered terms of one, two, three, four, and five years.
When the first CD matures at the end of the first year, you withdraw the interest earned and reinvest the principal into a new five-year CD.
By repeating this process annually, after five years you will hold five CDs, each earning the maximum interest rate available for a five-year term.
This laddering technique can be adapted to any investment amount and CD term lengths to suit your financial goals.
What to expect when your CD term is coming to an end
Several weeks before your CD reaches its maturity date, your bank will notify you (usually by U.S. mail) that your CD is about to mature.
The notice will include a description of your options and instructions about what to do once you select one. When CDs mature, you can withdraw your funds, roll them into a new CD, or transfer them to another account.
If you do nothing, the CD will typically renew automatically for the same term at the current interest rate.
Your options
When your CD reaches maturity, you have a number of choices:
- Withdraw your principal and interest and renew the CD
- Withdraw your interest and renew the CD
- Roll over your principal and interest into a new CD
- Add funds and purchase a new CD
- Withdraw the interest and a portion of the principal and buy a smaller CD
If you choose to cash out some or all of your CD when it matures, you will have the choice of receiving a check in the mail or transferring it to another account.
Whichever option you choose, you will have to notify the bank in writing or in person, as required by your bank.
If you don't follow your bank's rules for notifying them of the changes, they will be ignored.
What happens if you do nothing? Understanding the early withdrawal penalty
If you forget to respond to the notice or simply choose to do nothing, the bank will hold your money for a grace period of seven to 10 days, and then it will automatically renew for the same terms as the original CD.
This will result in you being subject to early withdrawal penalties, even if you remember one day after the CD auto-renews.
