How does a certificate of deposit (CD) work?

You have cash you want to set aside, and you're looking for an option that earns interest without the chance of losing any money. A certificate of deposit (CD) account can be that Goldilocks option, with just enough reward and not too much risk.

Let's take a closer look at the ins and outs of CDs. We'll cover these topics:

• How does a CD work?
• What are some common CD terms?
• When should you consider opening a CD?
• What are the different types of CDs?
• How do CD interest rates change?
• How are CDs taxed?
• Pros and cons of opening a CD
• CD FAQs
• Where can you get a CD?

How does a CD work?

When you open a certificate of deposit, you agree to let the bank hold on to your money for a specific amount of time, or term length. In return, the interest rates tend to be higher. Sometimes called a timed deposit, a CD requires you to leave your money until the end of the term length — or when it reaches the maturity date. If you need to close the CD or withdraw from it before it matures, you may pay a penalty.

What are some common CD terms?

Here are the basics of a certificate of deposit at a glance: 

Deposit amount

A CD may require a minimum deposit, which can affect the interest rate earned.

Interest rate

The interest rate on a certificate of deposit is fixed, so it stays the same throughout the term. The rate itself can be based on the term length and your initial deposit amount.

APY

The annual percentage yield of a CD represents the total amount of interest you'll earn on the CD in one year. It accounts for the base interest rate and how that interest rate compounds, or builds on itself over time.

Risks and penalties

CDs are low risk, as they're FDIC-insured and won't lose value. If you need to access the cash in the account before the end of the term, you have to pay a penalty and may forfeit a few months' worth of interest.

Renewal

At the end of the fixed term, you can renew the CD for the current interest rate. You can also close the CD and take your cash and earnings.

When should you consider opening a CD?

Think of a certificate of deposit as your middle-of-the-road investment option. It's less liquid than a traditional savings account but typically has higher interest. The return on a CD is typically lower than on stocks or mutual funds, but there's no risk of your investment value dropping.

For example, if you're planning to expand your family and want to set money aside to help you afford parental leave, opening a CD could make sense. You can choose the term length based on where you are in the process. If you plan to reach your goal within the year, you may choose a CD with a six-month term. If you're envisioning this savings goal happening in more than a year's time, a CD with a 14-month term could make sense.

However, if you see yourself needing your savings more immediately, to cover medical costs or other expenses associated with becoming a parent, it may make more sense to put your money in a regular savings account. The interest rate may be lower, but you can access the cash whenever without a penalty.

What are the different types of CDs?

Certificates of deposit may be more flexible than they first appear, depending on the type you choose. A few common CD options include:

Short-term CDs: Term lengths of less than 18 months.

Long-term CDs: Term lengths of 48+ months.

IRA CDs: Type of individual retirement account that holds a CD. It's a tax-deferred investment that earns interest at a fixed rate for the term's duration.

Callable CDs: Gives the bank the option to close the account and return your money to you before the term ends. A bank may choose to "call" your CD if interest rates are falling and banks can borrow money for less.

Jumbo CDs: Have minimum deposit amounts that are higher than usual, often $10,000 or more. The interest rate on a jumbo CD is often higher than on a traditional CD, but you may not want to lock up that much money at once.

How do CD interest rates change?

The Federal Reserve sets benchmarks for interest rates. If the Fed raises rates, CD rates also go up. If the Fed lowers rates, CD rates drop. Note that when you open a CD, the rate is fixed for the term. Even if rates elsewhere rise or fall, your CD's rate stays the same. You'll want to check on what's happening in the wider economy when you're considering if your CD rate may go up or drop.

How are CDs taxed?

Generally, you pay tax on the interest a certificate of deposit earns. There are a few exceptions, though. If you open a CD in a Roth IRA, you've paid tax on the deposit and don't have to pay tax on the earnings. If you open a CD in a traditional IRA, you pay deferred tax on the original deposit amount and the interest earned. However, you won't pay that tax until you withdraw from the IRA in retirement.

Always read the fine print so you understand the early withdrawal penalty before you open a CD.

Where can you get a CD?

Banks and credit unions offer CDs. In some cases, a bank may offer a different rate for CDs at its brick-and-mortar locations and online. Since rates can vary by financial institution, it's smart to shop around before you open a new account.

It's also worth comparing CD options at the same bank, as many institutions offer different rates for certain terms. While longer-term CDs often have higher interest rates, that's not always the case. You may get a better rate on a shorter-term CD that has a higher deposit minimum compared to a longer-term CD with a lower deposit.

If you're interested in learning more about this savings option to reach your financial goals, check out our CD rates and features.