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Certificates of deposit: What is it and how it works

CDs lock your funds away for guaranteed earnings — if you don’t withdraw early.

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By

Bethany Hickey

&

Cassidy Horton

Edited by

Bethany Hickey

Reviewed by

Alexa Serrano Cruz

Updated

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Certificates of deposit (CD) are deposit accounts offered by most banks and credit unions. They earn interest like savings accounts, but you’re required to keep your money in the account for a set period. There are many types of CDs, and they all have one thing in common: They earn a fixed interest rate.

What is a CD?

A certificate of deposit (CD), or share certificate, is a type of savings account that earns a fixed rate during a specific term length.

By opening a CD, you agree to your institution’s advertised rate and to keep your money in the CD until the term’s end when it matures. Once the CD approaches maturity, you’ll enter what’s called a grace period, which typically lasts between seven to 10 days. During this grace period, you’ll need to decide whether to close out the CD or renew it before the maturity date.

If you cash out the CD, you’ll choose where you’d like the bank to send your money. If you miss your grace period, the bank renews your CD for the same term length but under the most current rate.

With CDs, you’re required to pay taxes on the interest you earn. Like traditional savings accounts, the interest your CD attracts is reported to the IRS. Your bank will send Form 1099-INT for any account for which you’ve earned at least $10 in interest.

How do CDs earn money?

A CD gives you a fixed interest rate in return for investing your money for a fixed amount of time. Most CDs have monthly compounding interest, meaning the interest you’ve earned throughout the month is added to your deposit at the end of each month, so you’ll earn interest on your earned interest.

Are CDs safe?

Yes, CDs are safe as long as they are kept with an FDIC-insured institution, which usually insure you up to $250,000.

Is a certificate of deposit right for me?

A CD may be the right savings route for you if …

  • Have a separate emergency fund. CDs lock your money away, so in case of emergencies, it’s a good idea to have an emergency fund where you’ll keep funds accessible and ready to cover unexpected events.
  • Meet the deposit requirements. CDs almost always require a certain amount upfront, called an opening deposit, usually ranging from $100 to $1,000 for personal CDs. The CDs with the best rates may require higher deposits as well.
  • Want a higher rate. CDs tend to offer higher interest rates than traditional savings accounts, so moving funds out of your savings for a while can mean more earnings.
  • Won’t need those funds for a while. The sweet spot for the best CD rates tends to be around 12 to 18 months, so only open a CD if you’re prepared to leave the money alone for that long.

How to choose a CD

CDs are rather straightforward, but if you’ve never opened one before, consider these key factors:

  • Interest rate. The most important factor when comparing CDs is the interest rate and how often it compounds. The best CD rates are leaps and bounds above national averages.
  • Minimum deposit. The amount of cash you need to open a CD can vary widely depending on the institution. In many cases, you only need a few hundred dollars, but some banks require several thousand.
  • Available terms. If you’re thinking about a big purchase in the next few years — like buying a home — focus on shorter terms that can free your cash for a hefty down payment.
  • Potential fees. You never know what life will throw at you. Ask about fees for early withdrawals, just in case you can’t wait out the term or consider opening a no-penalty CD.

Pros and cons of CDs

CDs have more benefits than downsides, but they’re not for everyone.

Pros

  • Guaranteed returns. When you invest your money in a CD account, you’ll earn a guaranteed rate after your deposit matures. This protects you against any interest rate drops since your rate is locked in.
  • High interest rates. CDs allow you to earn a better interest rate on your money than most savings accounts can offer.
  • Variety of terms. Most banks and credit unions offer CDs as short as three months to as long as 10 years.

Cons

  • Opportunity cost. If interest rates go up, you lose out. Even if the bank’s interest rates rise while your money is locked away in a CD, your rate stays the same.
  • Funds are locked. If you need to access your funds before the term’s end, you’ll pay an early withdrawal penalty on the interest you’ve earned, which can be as much as 90 to 180 days’ worth of interest.
  • Can’t add more money. Once you’ve made your initial deposit, you can’t continue adding money to the CD for the entire term.

Certificate of deposit alternatives

A CD isn’t your only option when it comes to saving money. A savings account, treasury bond or money market account may make more sense based on your needs and goals.

Bottom line

If you have the time and money to lock away your savings for higher interest rates over a term of six months to five years or more, consider a CD. These safe investment tools guarantee a return on your investment, though with a potential disadvantage of penalties and fees if you can’t wait until your CD fully matures. For more information, learn how to make the most out of CDs.

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