How do CDs work?

If you're looking for a safe place to set aside some cash, a certificate of deposit (CD) could be right for you. CDs earn interest, and there's no risk of them losing value. Take a closer look at how CDs work, what to consider before opening one and if it's the right option for you.

What is a CD?

A CD is a type of deposit that allows you to earn interest on money you've set aside. When you open a CD, you agree to leave the money in the account for a specified term, such as six months, 12 months, 18 months or even 60 months. The length of the term influences the interest rate offered. Usually, the longer the term, the higher the interest rate.

At the end of the term, you typically have the option to renew the CD with a new interest rate based on the market. Or, you can cash out and save or invest the money elsewhere. If you need to withdraw from the CD before the term is up, you may have to pay a penalty, typically equivalent to a few months' worth of interest.

How does a CD work?

The process of opening and holding a CD is usually simple and straightforward:

1. Open the CD: You review the terms available from your bank and the interest rates on offer, then choose the one that works for you based on your needs and goals. For example, you may only want to lock down your money for a short period, in which case a six- or 12-month CD may make the most sense. If you know you won't need to access the cash for a longer period of time, a 24-month or longer CD may be ideal.
2. Earn interest: As the months pass, your CD will earn interest. Depending on the terms of the CD, interest may be added to the initial deposit amount every month or only at the end of the term. In many cases, customers can choose how their interest is handled by either allowing it to compound within the CD or having the monthly interest transferred to another account.
3. Wait until the CD matures: At the end of the term, the CD matures, and all the interest earned is yours.
4. Renew or close out the CD: Now you decide what to do with the money. You can renew the CD for either the same term length or a new length or withdraw the money and do whatever you'd like with it. Keep in mind that the interest rate may be different once the CD renews.

How to open a CD

Opening a CD is a straightforward process, but comparing options and understanding requirements can help you get the best rate.

1. Choose a bank or credit union: You can open a CD at either a bank or a credit union. In some cases, a financial institution may offer different rates at its brick-and-mortar locations versus online, so it's smart to shop around before opening a new account.
2. Compare CD terms and rates: Many institutions offer different rates depending on the CD term. While longer-term CDs often have higher interest rates, that's not always the case. You may find a better rate on a shorter-term CD with a higher deposit minimum than on a longer-term CD with a lower deposit.
3. Gather required information: When opening a CD, you'll need to provide contact information such as your residential address and Social Security number. You may also need to provide a form of ID, like a driver's license or passport, if you don't already have an account with the bank.
4. Meet the minimum deposit requirement: Depending on the bank and CD type, a minimum deposit may be required, such as $500 or $1,000, to open the account.

What to know about CD interest rates

Understanding how CD interest rates work can help you decide whether a certificate of deposit fits your savings needs.

• Interest rates are typically higher than those of other accounts: Since you're agreeing to leave the money in your CD for a set time period, the interest rate available is typically higher than for a standard savings account. Interest rates are based on benchmarks set by the by the Federal Reserve. When the Fed raises the benchmark, interest rates also rise, and may drop when the benchmark is lowered.
• CDs have a fixed interest rate: Even if the Fed raises or lowers rates during the term of the deposit, the rate on your CD won't change. When it's time to renew, the new rate will reflect the current benchmark and may be higher or lower than what was previously offered.
• CDs earn compound interest: The principal deposit earn interest and those earnings also earn interest. Compound interest is one reason why the annual percentage yield (APY) on a CD is usually slightly different from the interest rate. You can calculate the APY on a CD using the interest rate and the compounding rate, or how frequently interest is added to the initial deposit.

What are the 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 are considered short-term CDs.
• Long-term CDs: Term lengths of 48+ months are considered long-term CDs.
• IRA CDs: This is a type of individual retirement account that holds a CD. It's a tax-deferred investment that earns interest at a fixed rate for the duration of the term.
• Callable CDs: The bank has 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: These 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.

What to consider when 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 usually offers a higher interest rate. The return on a CD is typically lower than on stocks or money market accounts, but there's no risk of your investment value dropping.

For example, if you're planning to expand your family and want to set aside money 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, consider a CD with a six-month term. If you're envisioning this savings goal happening in more than a year, a CD with a 14-month term could make sense.

However, if you anticipate 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 you need it without a penalty.

Common FAQs about CDs

For more information about how CDs work, find answers to frequently asked questions here.

Is a CD FDIC-insured?

Yes, the Federal Deposit Insurance Corporation insures CDs for up to $250,000. The $250,000 limit covers any accounts you have at a single institution in the same account ownership category.

What's the difference between a CD and a high-yield savings account?

The main difference between a CD and a high-yield savings account is liquidity. You can typically withdraw from a savings account when you need to without a penalty.

How often does a CD pay interest?

CDs often credit interest to your account monthly, and the credited interest then starts to earn interest. You may be able to transfer the interest to another savings account or leave it in the CD until maturity.

What happens if you withdraw from a CD early?

Most CDs charge a penalty for early withdrawal. The penalty is often in the form of a few months' interest but may be a flat fee. Always read the fine print so you understand the early withdrawal penalty before opening a CD.

How are CDs taxed?

Generally, you pay tax on the interest a certificate of deposit earns, but there are a few exceptions. 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.

Ready to open a CD?

A CD account provides a safe place to stash your cash and can help you reach your financial goals. If you're interested in learning more about this safe and reliable savings option, check out our CD rates and features.