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.
The Balance

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 a pre-determined amount of time. 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. Historically, CDs came with fixed rates that didn't change, and you always would pay a penalty if you cashed out early. But that's not necessarily the case anymore.

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 also can 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 CDs insured through the Federal Deposit Insurance Corp. or the National Credit Union Administration. Don’t be afraid to ask your banker for a better rate, especially if you do significant business with that bank or credit union.

Types of CDs

Liquid or No Penalty CDs

Liquid CDs allow you to withdraw your funds early without paying a 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 may 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 withdraw funds and how much you can take at any given time. You also might be required to invest a greater amount upfront than with other types of CDs.

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. A bank assumes that you’re sticking with the existing rate if you do nothing. Also, 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 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.

Make sure that any issuer you’re considering is insured by the 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.

Maturity Dates

CDs mature at the end of their terms, 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 previously were earning.

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

Building a CD Ladder

If you're interested in using CDs as a key part of your savings plan, you might consider a ladder, a common CD investing strategy. The process involves first buying several CDs with different terms so they'll mature 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 1-year CD matures, you would move that money 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.

CDs vs. Savings Accounts

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 almost certainly will allow you to earn more interest on that money. Depending on how long you want to tie up your money and the amount of your deposit, you might actually double the amount of interest you earn.

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.

Be sure the money you are putting into CDs is money you won't need for unexpected expenses. Taking out a loan to address an emergency would almost certainly end up costing you far more in interest than you would ever earn on a CD.

Advantages of CDs

Before deciding whether or not to invest in a CD, consider your specific needs. Some of the reasons to consider a CD include:

  • Your money is insured: The FDIC insures CDs up to $250,000. The federal government guarantees you will never lose your principal. For that reason, they have less risk than bonds, stocks, or other more volatile investments.
  • Better rates than checking and savings: CDs usually offer higher interest rates than interest-bearing checking and savings accounts. They also offer higher interest rates than other safe investments, such as money-market accounts or money market funds.
  • You can comparison shop: You can shop around for the best rates. Small banks will offer better rates because they need funds. Online-only banks will offer higher rates than brick and mortar banks because their costs are lower. In addition, you likely will find higher-than-usual rates if you deposit a sizable amount of cash in the form of jumbo CDs.

Disadvantages of CDs

CDs aren't for everyone, and they might not fit your specific needs. Some of the reasons to steer clear include:

  • Early withdrawal fees: The main disadvantage is that your money is tied up for the life of the certificate. You pay a penalty if you need to withdraw your money before the term is up. However, there are several types of CDs that provide a certain amount of flexibility, so don't forget to ask your bank about options.
  • Interest rates could rise: You run the risk that interest rates will go up on other products during your term. If it looks like interest rates are rising, you can get a no-penalty CD. It allows you to get your money back without charge any time after the first six days. They pay more than a money market but less than a regular CD.
  • APYs lag behind inflation: CDs don't pay enough to keep up with the rate of inflation. If you invest only in CDs, you'll lose your standard of living over time. The best way to keep ahead of inflation is with stock investing, but that is risky. You could lose your total investment. You could get a slightly higher return without risk with Treasury Inflation-Protected Securities or I-Bonds. Their disadvantage is that you'll lose money if there is deflation.

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