What Is a Certificate of Deposit (CD) and What Can It Do for You?

What Is a Certificate of Deposit (CD)?

A certificate of deposit (CD) is a savings product that earns interest on a lump sum for a fixed period of time. CDs differ from savings accounts because the money must remain untouched for the entirety of their term or risk penalty fees or lost interest. CDs usually have higher interest rates than savings accounts as an incentive for lost liquidity.

Understanding Certificates of Deposit (CDs)

Opening a CD is very similar to opening any standard bank deposit account. The difference is what you’re agreeing to when you sign on the dotted line (even if that signature is now digital). After you’ve shopped around and identified which CD(s) you’ll open, completing the process will lock you into four things.

1. The interest rate: Locked rates are a positive thing because they provide a clear and predictable return on your deposit over a specific time period. The bank cannot later change the rate and therefore reduce your earnings. On the flip side, a fixed return may hurt you if rates later rise substantially and you’ve lost your opportunity to take advantage of higher-paying CDs.
2. The term: This is the length of time that you agree to leave your funds deposited to avoid any penalty (e.g., 6-month CD, 1-year CD, 18-month CD, etc.) The term ends on the maturity date, when your CD has fully matured and you can withdraw your funds penalty free.
3. The principal: With the exception of some specialty CDs, this is the amount that you agree to deposit when you open the CD.
4. The institution: The bank or credit union where you open your CD will determine aspects of the agreement, such as early withdrawal penalties (EWPs) and whether your CD will be automatically reinvested if you don’t provide other instructions at the time of maturity.

Once your CD is established and funded, the bank or credit union will administer it like most other deposit accounts, with either monthly or quarterly statement periods, paper or electronic statements, and usually monthly or quarterly interest payments deposited to your CD balance, where the interest will compound.

Why Would I Open a CD?

Unlike most other investments, CDs offer fixed, safe—and generally federally insured—interest rates that can often be higher than the rates paid by many bank accounts. And CD rates are generally higher if you’re willing to sock your money away for longer periods.

CDs have become a more attractive option for savers who want to earn more than most savings, checking, or money market accounts will pay, but without taking on the risk or volatility of the market.

CDs vs. a Savings or Money Market Account

CDs are a special type of savings instrument. Like a savings or money market account, they provide a way to put money away for a specific savings goal—such as the down payment on a house, a new vehicle, or a big trip—or to park funds that you simply don’t need for day-to-day expenses, all while earning a certain return on your balance.

But whereas savings and money market accounts allow you to vary your balance by making additional deposits, as well as up to six withdrawals per month, CDs require one initial deposit that stays in the account until it reaches its maturity date, whether that’s six months or five years later. In return for giving up access to your funds, CDs generally pay higher interest rates than savings or money market accounts.

How Are CD Rates Determined?

Anyone who’s been following interest rates or business news in general knows that the Federal Reserve’s rate-setting actions loom large in terms of what savers can earn on their deposits.1 That’s because the Fed’s decisions can directly affect a bank’s costs. Here’s how it works.

Every six to eight weeks, the Fed’s Federal Open Market Committee (FOMC) decides whether to raise, lower, or leave alone the federal funds rate.2 This rate represents the interest that banks pay to borrow and lend their excess reserves to each overnight through the Fed.3

The federal funds rate in turn influences the prime rate, the interest rate that banks charge their most creditworthy customers. The prime rate is generally the fed funds rate +3 percentage points.

Rates for CDs, savings, and loans are then influenced by the prime rate. The higher the prime rate, the more interest you can earn on a CD.

In December 2008, the Fed reduced its rate to the lowest level possible of essentially zero as a stimulus to lift the U.S. economy out of the Great Recession. Even worse for savers was that it left rates anchored there for a full seven years.1 During that time, deposit rates of all kinds—savings, money market, and CDs—tanked.

Fast-forward to 2022, when amid record-setting inflation, the Fed began to raise interest rates aggressively. Between March 2021 and March 2023, average CD rates tripled or quadrupled.45

Beyond the Fed’s action, however, the situation of each financial institution is an additional determinant of how much interest it is willing to pay on specific CDs. For instance, if a bank’s lending business is booming and an increasing amount in deposits is needed to fund those loans, then the bank may be more aggressive in trying to attract deposit customers. By contrast, an exceptionally large bank with more than sufficient deposit reserves may be less interested in growing its CD portfolio and therefore offer paltry certificate rates.

Are CDs Safe?

CDs are one of the safest savings or investment instruments available for two reasons:

• First, their rate is fixed and guaranteed, so there is no risk that your CD’s return will be reduced or even fluctuate. What you signed up for is what you’ll get—it’s in your deposit agreement with the bank or credit union.
• Second, CD investments are protected by the same federal insurance that covers all deposit products. The Federal Deposit Insurance Corp. (FDIC) provides insurance for banks, and the National Credit Union Administration (NCUA) provides insurance for credit unions. When you open a CD with an FDIC- or NCUA-insured institution, up to $250,000 of your funds on deposit with that institution are protected by the U.S. government if that institution were to fail.67 Bank failures are rare, but it’s good to know that a bank failure wouldn’t put your funds in jeopardy.

The key to ensuring your funds are as safe as possible is to make sure that you choose an institution that carries FDIC or NCUA insurance (the vast majority do, but a small minority carry private insurance instead), and to avoid exceeding $250,000 in deposits in your name at any one institution.67 If you are holding more than that amount in deposits, you can maximize your coverage by spreading your funds across multiple institutions and/or more than one name (e.g., your spouse).

When Is Opening a CD a Good Idea?

CDs are useful in a few different situations. Perhaps you have cash that you don’t need now but will want within the next few years—maybe for a special vacation or to buy a new home, car, or boat. For near-term uses like that, the stock market generally isn’t considered a suitable investment, as you could lose money over that period of time.

Or maybe you simply want some portion of your savings invested very conservatively, or you shun the risk and volatility of the stock and bond markets altogether. Though CDs don’t offer the growth potential of equity or debt investments, they also don’t carry a risk of downturns. For money that you want to absolutely ensure will grow in value, even if modestly, CDs can fit the bill.

One of the downsides of CDs can also be a useful feature for some savers. For those who worry that they won’t have the discipline to avoid tapping into their savings, the fixed term of a CD—and the associated penalty for early withdrawal—provide a deterrent to spending that regular savings and money market accounts do not.

One version of this is using CDs for your emergency fund. This allows you to ensure that you always have sufficient reserves on hand in case of an emergency because the amount in the CD will never decrease.

And though you may incur a penalty if you have to dip into your funds early, the idea is that you would only do this in a true emergency, not for lesser but tempting reasons. All the while, you’ll be earning a better return while the funds are invested than if you had deposited them in a savings or money market account.

Where Can I Get a CD?

Virtually every bank and credit union offers at least one CD, and most have a wide array of terms on offer. Thus, not only is your local brick-and-mortar bank an outlet, but so is every bank or credit union in your community, as well as every bank that accepts customers nationwide via the internet.

In addition, you can open CDs through your brokerage account. These are bank certificates as well. Your brokerage firm simply serves as a middleman.

Why It’s Important to Shop Around

With the growth of online banking, it’s now possible to shop for CDs at more than 150 banks that accept customers nationwide and allow for opening an account online. In addition to that, you’ll have access to a number of regional and state banks that will do business with you based on your residency in their state. And many credit unions are available nationwide to anyone who is willing to join an affiliated nonprofit organization for a small fee.

Note that the range of CD rates across different institutions can vary widely. It’s a mistake to just open a CD at the bank where you already have a checking relationship without investigating how its rates compare with those that you can earn elsewhere. You should shop for options available anywhere, with several online tools able to filter these results and aid in your search.

How Much Do I Need to Open a CD?

Each bank and credit union establishes a minimum deposit required to open each CD on its menu. Sometimes a bank will set a minimum deposit policy across all CD terms it offers, while some will instead offer rate tiers, providing a higher annual percentage yield (APY) to those who meet higher minimum deposits.

In theory, having more funds available to deposit will earn you a higher return. But in practice, this doesn’t always hold true. For instance, having $25,000 ready for deposit will occasionally enable you to open a CD that is not available to others with lesser amounts. But many of the top 10 rates in each CD term can be achieved with modest investments of just $500 or $1,000. And the vast majority of top rates are available to anyone with at least $10,000. A $25,000 deposit is only occasionally required for a top rate.

Which CD Term Should I Choose?

There are two important considerations when deciding what length of CD term is right for you.

The first centers on your plans for the money. If it’s for a specific goal or project, the expected start of that project will help you determine your maximum CD term length. In contrast, if you’re just socking away cash for which you don’t have a specific purpose in mind, you may opt for a longer term to maximize your interest rate.

Second, you’ll want to consider what’s expected to happen with the Fed’s rate. If it’s anticipated that the Fed will raise rates—and bank and credit union CD rates will likely rise as well—then short- and mid-term CDs will make more sense than long-term CDs, since you won’t want to be committed to a lesser rate for five years when new, higher rates appear. Conversely, an expectation that rates will decrease in the near term may trigger you to want long-term CDs, so you can lock in today’s higher rates for years to come.

One other way to invest in CDs when interest rates are rising is to buy a variable rate CD or a bump-up CD. A variable rate CD has an APY that changes based on an index rate—it can go up or down, so you only want to buy a variable-rate CD when rates are expected to go up and stay up. A bump-up CD allows you to increase the rate at one time of your choosing, and the rate can not go down.

What Is a CD Ladder, and Why Should I Build One?

Smart CD investors have a specific tactic for hedging against rate changes over time and maximizing their returns. It’s called a CD ladder, and it enables you to access the higher rates offered by 5-year CD terms, but with the twist that a portion of your money becomes available every year rather than every five years. Here’s how to do it.

At the outset, you take the amount of money that you want to invest in CDs and divide it by five. You then put one-fifth of the funds into a top-earning 1-year CD, another fifth into a top 2-year CD, another into a 3-year CD, and so forth through a 5-year CD. Let’s say you have $25,000 available. That would give you five CDs of varying length, each with a value of $5,000.

Then, when the first CD matures in a year, you take the resulting funds and open a top-rate 5-year CD. A year later, your initial 2-year CD will mature, and you’ll invest those funds into another 5-year CD. You continue doing this every year with whichever CD is maturing until you end up with a portfolio of five CDs all earning 5-year APYs, but with one of them maturing every 12 months, keeping your money a bit more accessible than if all of it were locked up for a full five years.

Why You Should Be Open to Odd-Term CDs

Whether you’re building a CD ladder or are saving toward a specific goal with a known time line, stay open-minded to the very best CD deals you find rather than getting hung up on a specific term. This is important because when some banks and credit unions offer a promotional CD to attract new customers, they may stipulate an unconventional term.

For instance, some of the best CD rates you’ll see have unlikely terms such as 5 months, 17 months, or 21 months. It may be to stand out, or perhaps to match an anniversary that the bank is celebrating, or for any number of other reasons. But if you can be flexible in considering these odd-term CDs instead of the conventional term that you were planning, you can sometimes find yourself with a better-paying opportunity.

How Are CD Earnings Taxed?

When you hold a CD, the bank will apply interest to your account at regular intervals. This is usually done either monthly or quarterly and will show up on your statements as earned interest. Just like interest paid on a savings or money market account, it will accumulate and be reported to you in the new year as interest earned, so that you can report it as income when you file your tax return.8

Sometimes people get confused about this because they are not able to actually withdraw and use those interest earnings. Their expectation is that they will be taxed on the earnings when they withdraw the CD funds at maturity (or sooner if they cash out early). This is incorrect. For tax-reporting purposes, your CD earnings are taxed when the bank applies them to your account, regardless of when you withdraw your CD funds.8

What Happens to My CD at Maturity?

In the month or two leading up to your CD’s maturity date, the bank or credit union will notify you of the impending end date. Its communication will also include instructions on how to tell them what to do with the maturing funds. Typically, they will offer you three options.

1. Roll over the CD into a new CD at that bank. Generally, it would be into a CD that most closely matches the term of your maturing CD. For example, if you have a 15-month certificate concluding, they would likely roll your balance into a new 1-year CD.
2. Transfer the funds into another account at that bank. Options include savings, checking, or money market account.
3. Withdraw the proceeds. They can be transferred to an external bank account or mailed to you as a paper check.

In any case, the communication to you will stipulate a deadline for you to provide instructions, with an indication of what the institution will do in lieu of receiving your guidance. In many cases, its default move will be to roll your proceeds into a new CD.

Should I Let My CD Roll Over?

As a general rule, letting your CD roll over into a similar CD term at the same institution is almost always unwise. If you still don’t need the cash and are interested in starting a new CD, rolling it over is certainly the path of least resistance. But it’s also virtually never the path of maximum return.

As we’ve mentioned, shopping around is imperative if you want to earn the top rate on your CD investments. And the odds are low that the bank where your CD is maturing is currently a top-rate provider among the hundreds of banks and credit unions from which you can choose a CD. It’s possible that you’ll do well with a rolled-over CD, but the probabilities are against you, and shopping around is always your better bet.

Even if you find that your existing bank is indeed a top contender, you’ll be able to move into that CD purposefully and with confidence that you’ve done your homework to score the best possible return.

What If I Need to Withdraw My Money Early?

Even though opening a CD involves agreeing to keep the funds on deposit without withdrawals for the duration of the term, that doesn’t mean you lack options if your plans need to change. Whether you encounter an emergency or a change in your financial situation—or you simply feel that you can use the money more usefully or lucratively elsewhere—all banks and credit unions have stipulated terms for how to cash your CD out early.

The exit won’t be free, of course. The most common way that financial institutions accommodate a premature termination is by assessing an early withdrawal penalty (EWP) on the proceeds before your funds are distributed, according to specific terms and calculations that were set out in your deposit agreement when you first opened the certificate. This means that you can know before you agree to the CD if the EWP is acceptable to you.

Most typically, the EWP is charged as a number of months’ interest, with a greater number of months for longer CD terms and fewer months for shorter CDs. For instance, a bank’s policy might be to deduct three months’ interest for all CDs with terms up to 12 months, six months’ interest for those with terms up to three years, and a full year’s worth of interest for its long-term CDs. These are just examples, of course—every bank and credit union sets its own EWP, so it’s important to compare EWP policies whenever you are deciding between two similar CDs.

It’s especially wise to watch out for EWPs that can eat into your principal. The typical EWP policy described above will only cause you to earn less than you would have if you had kept the CD to maturity. You will generally still have earnings, as the EWP will usually only eat up a portion of your earned interest.

But some particularly onerous penalties exist in the marketplace, where a flat-percentage penalty is applied. Since this percentage can outweigh what you’ve earned on a CD that you haven’t kept very long, you could find yourself collecting less in proceeds than you invested. As a result, these EWP types are best avoided.

The Bottom Line

Certificates of deposit offer stability for people that want to earn more on their money without the risk inherent in stocks and bonds. Although interest rates may be higher than savings accounts and money markets, you’ll want to read the fine print carefully. Tying up your money for long set terms may be safe, but you may lose out on higher interest returns if the federal funds rate increases. While you may be able to withdraw your money early, there will be penalties, some of which can cut into your principal. Know the limitations and benefits of your future investment before you sign on the dotted line.