How 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 in the account for a specified period of time. It's possible to get it out early, but you'll most likely pay a penalty.

How Does a CD Work?

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

A CD is 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 and 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."

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 always pay a penalty if you cashed out early. But that's not necessarily the case anymore.

Liquid or "No Penalty" CDs

Liquid CDs allow you to pull out your funds without paying an early withdrawal penalty. This flexibility enables 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 on the risk of rising interest rates. Still, earning less for a short period might be worth it if you can switch to a higher rate later—and if you're confident 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. You are also typically required to invest a greater amount upfront than with other types of CD.

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 the new, higher rate your bank is offering.

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. And you don’t get unlimited bump-ups.

Like liquid CDs, bump-up CDs often 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 or seven months. 

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 issuers 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 issuer you’re considering is insured by the Federal Deposit Insurance Corp. (FDIC). 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 as much as $250,000 of it is FDIC insured, and you'll earn a significantly higher interest rate.

CD Safety

All CDs issued by a bank or credit union are treated the same as insured deposits and are guaranteed—the former by the FDIC and the latter by the National Credit Union Association (NCUA)—up to $250,000. So in the event your bank or credit union goes belly up, the U.S. government will ensure you get all of your money back.

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 good place to keep cash that you can’t afford to lose but won't need to use anytime soon.

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 and your CD was subject to automatic renewal, your money will be reinvested into another CD. If you were in a six-month CD, it would be rolled over into another six-month CD. The interest rate may be higher or lower than the rate you were previously earning.

Let your bank know before the renewal deadline if you want to do something other than roll over your money 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.

Pros and Cons of a Long-Term CD

You'll usually earn a higher interest rate when you go with a longer-term CD, 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, which usually consists of a fee plus the forfeiture of a number of months of interest.

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.

A CD vs. a Savings Account

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.

However, if the money in your savings account is your emergency account, set aside as a hedge against job loss or illness, you might want to just leave that money in place. Perhaps you could start a new savings account with the idea of eventually investing that money in a CD.

You saved your emergency fund for a reason, and you wouldn't want to risk depleting it. And taking out a loan to address the emergency would almost certainly end up costing you far more in interest than you would ever earn on a CD.

Building a CD Ladder

If you're interested in using CDs as a key part of your savings plan, you might consider a ladder, the most common CD investing strategy. You would first buy several CDs with different terms so they'll be maturing at regular intervals and then reinvest the money into longer-term CDs as the initial ones mature.

For example, if you are saving $5,000, you can place $1,000 in each of five CDs with maturity dates a year apart. 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. Because a CD would mature each year, you could continue this process indefinitely until you needed the cash in any given 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

Rates for CDs have risen slightly after falling to historic lows following the Great Recession.

Different issuers will offer a range of interest rates for a CD of the same term. 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 are frequently able to offer higher rates.

You can also 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.

On April 5, 2020, Georgia's Own Credit Union was paying an APR of 1.6 percent on a one-year CD and an APR of 2.27 percent on a five-year CD. And Marcus by Goldman Sachs was offering a 1.7% APR on a seven-month CD with no early withdrawal penalty.

How to Start Using CDs

Contact your bank or credit union if you choose to open a CD with your local financial institution. Most banks will explain your options and allow you to make CD investments online. You can also call customer service or 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 may 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 do significant business with that bank or credit union.

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