How Do Certificates of Deposit – CDs Work?

Interest Rates, Terms, Types and More

Certificates of deposit (CDs) are among the safest investments available from banks and credit unions. They typically pay higher interest rates than savings accounts and money market accounts, but there’s one drawback. You have to lock up your money up in the account for a specified period of time. It's possible to get out early, but you'll most likely pay a penalty.

How Does a CD Work?

Graphic showing Liquid, Bump-up, and Brokered CDs.

CDs are a form of time deposit. In return for a higher interest rate, you promise to keep your cash in the bank for six months, 18 months, or even several years. The bank agrees to pay you more interest than you’d get from a savings account in exchange for that agreement. You'll receive a higher annual percentage yield (APY) on the funds you deposit because the bank knows that it can use your money for longer-term investments like loans. You won’t come asking for it next week.

It's up to you how long you want to keep your funds locked up when you open a CD. This time period is called the "term."

Liquid or "No Penalty" CDs

CDs come in a variety of forms, and banks and credit unions continue to offer new options to customers. Historically, CDs came with fixed rates that didn't change, and you would pay a penalty if you cashed out early. But that's not always the case anymore.

Liquid CDs allow you to pull your funds out at any time without paying an early withdrawal penalty. This flexibility allows you to move your funds to a higher paying CD if the opportunity arises, but it comes at a price.

Liquid CDs pay lower interest rates than CDs that you’re locked into. This makes sense if you look at it from the bank’s point of view — they’re taking all the risk. Still, earning less for a short period might be worth it if you can switch to a higher rate later and you're confident that rates will rise soon.

Make sure you understand any restrictions if you're thinking of investing in a liquid CD. Sometimes you’re limited to when you can pull funds out, and there might be restrictions on how much you can take at any given time as well.

Bump-Up CDs

Bump-up CDs provide a benefit similar to liquid CDs: You don’t get stuck with a low return if interest rates rise after you buy one. You get to keep your existing CD account and switch to a new, higher rate, assuming your bank is offering higher rates.

You might have to inform your bank in advance that you want to exercise your bump-up option. The bank assumes that you’re sticking with the existing rate if you do nothing. You don’t get unlimited bump-ups.

Like liquid CDs, bump-up CDs start out paying lower interest rates than standard CDs. You can come out ahead if rates rise enough, but if rates stay stagnant or fall, you would have been better off with a standard CD.

Step-Up CDs

These come with regularly scheduled interest rate increases so you're not locked into the rate that was in place at the time you bought your CD. Increases might come every six months, every nine months, or in the case of long-term CDs, once a year.

Brokered CDs

Brokered CDs are another alternative. Sometimes they offer better rates, but sometimes you’re better off going straight to your bank or credit union.

Brokered CDs are sold in brokerage accounts. You can buy brokered CDs from numerous banks and keep them all in one place instead of opening an account at a bank and using their selection of CDs. This gives you some ability to pick and choose, but brokered CDs come with additional risks.

You’ll want to make sure that any bank you’re considering is FDIC insured — not surprisingly, CDs without insurance are likely to pay more. Getting out of a brokered CD early can be challenging as well.

Jumbo CDs

As the name suggests, jumbo CDs have very high minimum balance requirements, usually in excess of $100,000. It's a safe place to park a large amount of money because it's FDIC insured, and you'll earn a significantly higher interest rate.

CD Safety

CDs are similar to cash in your savings or checking account, although you can't make withdrawals at will without paying a penalty. Assuming your deposits are FDIC insured or covered under NCUA insurance if you use a credit union, you’ve got a government guarantee. The U.S. government will ensure that you get all your money back if your bank goes belly-up.

As with any investment, you should choose between risk and potential reward. CDs fall on the low-risk, low-return end of the spectrum. They’re a great place to keep cash that you can’t afford to lose because you'll need to spend it within the next few years.

Maturity Dates

The CD “matures” at the end of its term, and you'll have to decide what to do next. Your bank will notify you as you near this date, and it will give you several options. If you do nothing, your money will most likely be reinvested into another CD with the same term as the one that just matured.

For example, you would automatically be put into another six-month CD if you were in a six-month CD. The interest rate might be higher than the rate you were previously earning, or it might be lower — there’s no guarantee that you get to keep the same rate.

Let your bank know before the renewal deadline if you want to do something other than reinvest into a new CD. You can transfer the funds to your checking or savings account, or you can switch to a different CD with a longer or shorter term.

Is Long-Term Better?

You'll usually earn a higher interest rate when you go with a longer-term, but this isn't always the best idea. You might need your money before the term ends. If you pull your funds out early — which is almost always an option, but banks and credit unions have been known to deny these requests in some rare cases — you’ll have to pay that early withdrawal penalty. The penalty will eat into any interest you've earned to date, and it might even take a bite out of your initial deposit.

It’s impossible to time anything perfectly, but it’s worth paying attention to what interest rates are doing and making some guesses as to how the future might unfold. You could guess wrong, however, so be sure to hedge your bets.

If you believe that interest rates are high and that they’re only going to drop, long-term CDs might make sense. But if you don't think you'll need the money for several decades, evaluate other investments in addition to CDs for your long-term goals.

Who Can Benefit From CDs?

If you're sitting on a lump sum of cash in a traditional savings account and you're reasonably sure you're not going to need that money for a while, putting it in a CD could be just the thing for you. It will almost certainly allow you to earn more interest on that money. Depending on how long you want to tie your money up and the amount of your deposit, you might actually double the amount of interest you earn.

When a Savings Account Is Better

If the money you've accumulated in savings is your emergency account, set aside as a hedge against job loss or illness, you might want to just leave that money in place. Maybe start new savings account with the idea of eventually taking that money and investing it in a CD or two or four. You saved your emergency fund for a reason, and you might not want to risk depleting it.

In the event that an emergency does arise and your money is in a CD, you're probably going to pay several months' worth of interest if you cash out early, which pretty much negates the whole purpose of putting the money in a CD in the first place. And neither NCUA or FDIC insurance covers these early-withdrawal penalties.

You might consider taking out a loan to address the emergency, but the interest you'll pay on a loan will in all likelihood be more than what you're earning on that CD.

Building a CD Ladder

You'll lock yourself into a low-paying CD for the next five years if you purchase a 60-month CD when interest rates are low. What if interest rates and CD rates rise in the next year or two? You might be better off using shorter-term CDs that renew with higher rates.

Evaluate strategies to help optimize your saving if you're interested in using long-term CDs. The most common strategy CD investors use is the ladder. Buy several CDs with different terms so they'll be maturing at regular intervals so you’ll have money available or you can reinvest at better rates.

For example, if you are saving $5,000, you can place $1,000 in each of five CDs with different maturity dates. When the one-year CD matures, you would move that money over into a new five-year CD, which would mature the year after your initial five-year CD does. You can continue with this process unless and until you need the cash in any given year because one would mature each year.

Ladders help you avoid locking up all your money in a low-paying CD, and they help you avoid cashing out early and paying penalties.

CD Rates

Different banks and credit unions will offer different interest rates for any given CD. Use strategies and products that match your goals, and shop around to maximize the APY you earn on your savings.

Online banks are often good choices because they don’t have the same overhead as brick-and-mortar institutions, so they're often able to offer higher rates. At the end of 2018, Synchrony Bank was paying 2.75 percent on a one-year CD, up to 3.10 percent on a five-year CD. Capital One was just a step behind in January 2019, offering 2.70 percent on one-year CDs and the same rate for longer-term for CDs.

Now compare that with Wells Fargo. They were offering just 1.25 percent on nine-month CDs, less than half of what you could have gotten from Synchrony or Capital One if you had just invested for three additional months. Even Wells Fargo's 19-month CD offers only 2.55 percent as of January 2019.

But you can certainly purchase CDs wherever you already have your checking and savings accounts. Or look for “specials” from local banks and credit unions to find good deals. They might appear in advertisements online or in local news sources. When banks and credit unions want to attract deposits, they offer especially high-interest rates to grab your attention.

How to Start Using CDs

Contact your bank or credit union to put money into a CD. Most banks will explain your options and allow you to make CD investments online. You can also call customer service, or even speak with a banker in person.

Explain how much you’d like to invest, and ask about early withdrawal penalties and alternative CD products. The bank might have additional CD options that are a better fit for you. They might offer higher rates, more flexibility, or other features.

You’ll see a separate account on your statements or online dashboard after you move your money into a CD.

CDs can also be held in almost any type of account, including individual retirement accounts (IRAs), joint accounts, trusts, and custodial accounts.

Just be sure to stick with FDIC-insured or NCUA-insured CDs, and don’t be afraid to ask your banker for a better rate, especially if you work with a small bank or credit union and do significant business with them. You might be able to earn a little more.