What are certificates of deposit (CDs) and how do they work? (2024)

Certificates of deposit (CDs) are simple and secure investments that can give you a decent return on your balance. They are a fantastic option if you’re looking for an interest-earning account that you can set and forget.

With a federally insured financial institution, your money is safe in the event of a bank run or closure. In exchange for leaving your money for the term, CDs may offer higher interest rates than other savings options.

Many types of CDs are available to match your financial needs, whether you’re looking for higher interest rates, more accessibility or different term durations.

So what are certificates of deposit, and how do they work?

What is a certificate of deposit?

A certificate of deposit is a specific type of savings account designed to give you a better return in exchange for less flexibility with your funds.

While typical savings accounts only earn interest of less than one percent each year, CD accounts often pay out much higher returns. Unlike a traditional savings account, however, you can’t simply withdraw money from a CD account when you need it. You’ll have to wait until the CD’s maturity date, a period of time that can range anywhere from a few months to several years after the account is opened. If you withdraw before that date, you can be penalized with fees.

How does a certificate of deposit work?

You deposit a lump sum into an account for a fixed period of time, during which the account holder is paid interest by the bank, generally daily or monthly. Once a CD reaches its maturity date, the account holder has the option to either withdraw their original deposit plus the interest earned or renew the CD for an additional term.

There are three main factors to understanding how a CD works:

1. Deposit amount: The dollar amount that is put into the account
2. Term: The period of time until the account matures
3. Interest rate: The annual percentage yield the bank pays the account holder in interest

Let’s look at an example to understand what type of return you might expect from a CD account. For instance, if you invested $10,000 into a 3-year CD with a 4% fixed interest rate, your account balance would look something like this:

Your initial investment of $10,000 would have grown to $11,248.64 by the CD’s maturity date for a total return of $1,248.64.

Benefits of investing in a certificate of deposit (CD)

CDs are a low-risk investment

Compared to other investment options like stocks and bonds, CDs are generally considered very low risk thanks to their fixed interest rate. This means that when you open a CD, the interest rate you receive won’t change for its entire term.

CDs typically offer higher returns than savings accounts

If the majority of your money has been sitting untouched in a savings account for years, it’s likely been losing value because of inflation. Since CDs typically offer higher interest rates than traditional savings accounts, depositing some of those funds into a CD can help your hard-earned savings keep their value, though in high inflation, CD rates can also fall behind.

However, always make sure to keep enough funds in your savings account that are quickly available to cover major unforeseen events, such as job loss or a serious illness.

CDs have flexible terms

When you open a CD account, you get to choose the terms that best suit your financial needs. If you’re saving up for a major purchase or setting aside cash for holiday spending, a short-term CD that matures in the next few months probably makes the most sense. Long-term goals such as retirement planning or saving for a child’s education, however, might be better suited by a 5-year or 10-year CD.

Risks associated with certificates of deposit

CDs often have penalties for early withdrawal

When your money is kept in a savings account, it’s typically easy to access on short notice for an emergency. When you deposit funds into a CD, however, you should generally plan on not touching the account until its maturity date. While it’s possible to withdraw funds early, you’ll usually be penalized with fees for doing so.

CDs can underperform inflation

The high interest rates offered by CDs are what attract many consumers to them, but you should always compare current CD rates to inflation before making a decision. If annual inflation rises above the interest rate on your CD during its term, you’ll find yourself having effectively lost money by the time it matures.

You’ll have to determine the balance of risk you want to take on in your investment. A CD typically delivers a relatively high rate of return with a very low risk, compared to something like investing in the stock market that could deliver a high return that keeps pace with inflation but can be risky.

CDs are subject to bank stability

Like any type of savings account, CD investments are only as secure as the bank holding them. If your bank goes under, there’s a chance your funds will go with it.

“This was hardly a thought a few years ago but must be a consideration today,” warns Mark Charnet, founder and CEO of American Prosperity Group, a financial estate planning firm.

In the event of bank failure, FDIC insurance will protect the balance of your CD account up to $250,000 – which is why it’s so important to make sure your bank is FDIC-insured.

However, Charnet warns, many customers fail to consider how long it might take to process such a claim. “FDIC insurance is wonderful, but how long would one wait to get their money back?”

Federal law requires the FDIC to make payments as fast as possible, and this can happen as quickly as the next business day after a bank closing. But there are some situations where the reimbursem*nt needs supplemental documentation, and every bank failure is unique, so the timeline may take longer.

Where to get a CD?

Traditional banks

When you start thinking about where to open a CD, the first option that comes to mind may be the same bank where you already have a checking and savings account. Just about every major bank makes CDs available to its customers. Getting in-person assistance and opening a CD at a local branch is often a major selling point for beginning investors.

But don’t jump to open a CD at your neighborhood bank branch purely out of convenience. CD rates at traditional banks can fall significantly lower than those offered by online banks and credit unions. Try to compare rates at a few different institutions before signing on with your existing bank.

Online banks

Recent years have brought a rise in the popularity of online banks. Since these financial institutions don’t operate physical branches and therefore have fewer overhead costs, they often tout more attractive rates than their traditional counterparts. CDs are no exception; in fact, many of the best CD rates on our list come from online banks.

Credit unions

While credit unions offer many of the same accounts and services as banks, they differ by operating as not-for-profit organizations. Any profits made by a credit union are typically distributed among account holders in the form of lower fees and more favorable rates. If you’re eligible for membership at a credit union, it may be worth asking about CD rates to see what’s available. Note that credit unions usually call this type of account a share certificate.

Brokerage accounts

You can buy a “brokered CD” through an investment firm. These are CDs that investment firms purchase through banks and then offer to you. Because brokerages have a larger pool of money, they can often negotiate better CD rates and a wider selection of terms. You can also sell a brokered CD on the secondary market without incurring early withdrawal penalties. These CDs may come with a maintenance fee. You’ll also want to confirm that the bank that issued them is federally insured.

How to choose the right certificate of deposit

When considering investing in a CD, there are several factors to take into account:

• Interest rates: Shop around for the best rates. They will vary depending on the financial institution, CD type, accessibility level and term length.

• Duration: CD terms can range from one month to five years or longer. Remember that you usually can’t access your funds without penalty during the term.

• Penalties: Banks and credit unions may charge hefty penalties for early withdrawal. If you think you may need to access the money, consider a no-penalty CD or another savings option.

• Investment amount: How much do you want to invest? Make sure to only to invest money you won’t need during the term.

• Interest payment frequency: Banks may issue interest payments weekly, monthly or at maturity. Collecting payments at the end of the term may be more lucrative because of compounding.

• Market conditions: If interest rates are expected to rise, you may want a shorter-term CD that you can renew at a better rate later. During times of rising inflation, it could outpace CD rates, so another investment may be a better option.

Which CD term to choose?

One key advantage of CDs is that you can choose the term that best suits your needs.

Most banks and credit unions offer a selection of CDs, often ranging from three months to five years. Interest rates typically vary depending on the length of the term. When researching CDs, you’ll want to compare rates from different banks as well as rates from different terms at the same bank. For example, the APY for a six-month CD may be considerably higher than the APY for a three-month CD at the same institution, and that higher interest could be an important factor in which term you choose.

Generally speaking, short-term CDs may be ideal if you expect you may need the money in the near future or you’re concerned about losing access to liquid funds for an extended time. However, short-term CDs sometimes offer a lower interest rate than you would get with a longer term.

Long-term CDs that won’t mature for several years may require more financial stability and careful planning. These can be solid options if you’re saving for future events, such as a major purchase or a child’s education. A long-term CD can also be appealing if you expect interest rates to drop and you want to lock in a high APY.

Some people choose to spread out their funds into multiple CDs with various terms, a strategy known as “laddering.” Laddering several CDs that mature at different intervals can give you regular opportunities to pull out cash as needed.

How do I find the best CD rates?

Finding the best CD rates may take some time and a little digging, especially if you want to compare rates from both online banks and financial institutions in your immediate area. Either way, you should know that CD rates can vary dramatically across banks and credit unions, and even across various types of CDs and terms each one offers.

Many financial institutions also offer ongoing “CD specials” with rates and terms that are much higher than they offer for other CDs. For example, you might earn twice as much interest (or more) with an 11-month CD versus a 12-month CD with some institutions, whereas others might extend the best rates for several different CD tiers. To find the best CD rates available today, consider the following tips:

• Start your search online: First off, you should know that the best CD rates are often available through online banks, even ones you have never heard of. To find the best rates, you should spend some time browsing and comparing CD rates with different online institutions.
• Compare multiple CD terms: Consider more than one CD term that could suit your needs, especially when the difference in rates is significant. While long-term CDs typically pay a higher interest rate, this may not be the case in certain rate environments. In fact, the top CD rates available as of April 2024, were for 6-month terms.
• Check out minimum deposit requirements: Also make sure banks you’re considering have a minimum deposit requirement you can easily meet. While some of the best CDs available today let you open a CD in any amount, others require a minimum of $500, $1,000 or more.
• Look for “ramp up” CDs: Some CDs are marketed as “ramp up CDs” or “rate bump CDs.” In either case, these CDs let you lock in a competitive rate today with the potential to receive a higher rate if market conditions change.
• Confirm the bank offers FDIC insurance: Whichever bank and CD term you decide on, make sure the financial institution is FDIC-insured. This insurance protects up to $250,000 per depositor, per financial institution and per account type.

Best CD rates of April 2024

The chart below highlights some of the best CD rates available today.

Early withdrawal penalties

CDs offer higher interest rates than other savings options because you’re leaving your deposit for the term.

Your financial institution may charge early withdrawal penalties if you need the money back before maturity. The amount varies depending on the bank and CD terms.

When you cash out early, you lose some of the interest your CD earned or would have earned. For example, if you have a 12-month CD with Bank of America and withdraw your funds early, you will lose 90 days of interest on the amount withdrawn. It’s possible for penalties to even eat into the principal.

Usually, you can’t just take out a portion of the money. If you need any of the funds back, the entire CD will likely end.

Only investing what you know you won’t need during the term is essential to avoid penalties. If there is any uncertainty, a no-penalty CD or a different savings product may be a better option.

Understanding maturity dates

Your financial institution is required to notify you before your CD matures. After maturity, you must instruct the bank on what to do with the funds. There are a few options available:

• Roll it into a new CD: You can open a new CD at the same financial institution. However, shop for better rates first in case the same bank or credit union is no longer offering the best rate.

• Transfer funds to another account: You can deposit the proceeds into another account at the same financial institution, like a savings or money market account.

• Withdraw the funds: You can request that the financial institution send you a check or transfer the money to another financial institution.

While there is usually a grace period to withdraw your funds, keeping track of your CD’s maturity date is crucial. If the financial institution doesn’t receive instructions on what you’d like to do with the CD, it may use your funds to open a new CD with the same terms.

Deciding whether to let your CD roll over

As your CD’s maturity date approaches, you’ll be faced with the question of whether to let the account roll over or withdraw the funds for a different use. Since this is the only opportunity to make a penalty-free withdrawal from your CD, it may feel like a difficult decision to make, particularly in the short window your bank gives you to take action.

If you’re not sure whether you should let your CD roll over, here are a few questions to ask:

• Will the new CD’s interest rate be higher or lower than the current rate?
• Can I find better rates at another bank or credit union?
• Am I happy with the existing term length? Should I switch to a longer or shorter term?
• Would these funds be better used paying off high-interest debt?

Withdrawing funds before maturity

Cashing out a CD before it matures is rarely advised, but unusual circ*mstances can sometimes make it the best option. If a major financial emergency arises and your only options are to withdraw from your CD early or take on high-interest debt, the former is often the most logical choice.

If you’ve concluded that tapping funds from your CD is your only course of action, contact your bank or credit union and ask how to begin the withdrawal process. Your bank will inform you of the penalty you’ll be charged for making the early withdrawal. Early withdrawal penalties typically correspond to a certain number of months’ or years’ interest earnings, depending on the CD’s original term.

Types of CDs

There are many different types of CDs. Here are some of the most common options:

• Traditional CDs: A traditional CD is a one-time deposit account with a fixed interest rate. You cash it out at the end of the term, and there are typically penalties for withdrawing early.

• High-yield CDs: A high-yield CD is like a traditional one but usually has higher interest rates.

• Bump-up CDs: If your bank raises the APY on its CDs, you can tell it to bump you up to that rate. You’re usually allowed one bump-up per term, but these CDs typically have a lower starting APY than traditional CDs

• Liquid (no-penalty) CDs: Liquid CDs may let you withdraw your money without penalty, but they usually have lower interest rates than traditional CDs.

• Brokered CDs: Brokerages offer CDs you can trade on the secondary market, similar to bonds. However, there’s more risk involved unless you plan to hold the CD until maturity.

How to open a certificate of deposit account

1. Choose the bank and CD account you’d like to apply for.
2. Fill out an application. You’ll need to provide personal details, so have your ID and Social Security number handy.
3. Deposit funds into your CD account. The bank will give you instructions on how to transfer money from your account into your new CD.
4. Set a calendar reminder for the CD’s maturity date. When your CD matures, you’ll need to notify the bank right away if you’d like to withdraw your funds – otherwise, your account might automatically renew for another term.

Savvy strategies to maximize CD returns

If you decide CDs are the best investment option for you, there are strategies you can use to maximize your returns.

“Shop around at online banks for high-interest CDs,” said Christopher L. Stroup, certified financial planner and financial advisor at Abacus Wealth Partners, a financial planning firm. “Many of the best CD rates possible in the marketplace can be found at a reputable online bank.”

You should also ensure that you won’t need the funds during the CD’s term.

“CD accounts can charge high penalties for withdrawing money early. Depending on the fine print of your investment, you could lose several months of interest you’ve earned by requesting money before the date of maturity,” said Stroup. “Having a separate emergency fund can help greatly by acting as a cushion against unexpected expenses, which can preserve your CD to maximize returns.”

Stroup also suggests using a laddering strategy to increase your return rate.

“A CD ladder includes splitting your investment across several CDs that each have a different term, such as 3 months, 6 months, 12 months and 18 months. As each of those matures, you can decide to withdraw your investment or reinvest it in a longer-term CD with a higher rate to maximize your earnings.”

How CDs are taxed

The interest you earn from CDs is subject to income tax just like any other interest-earning account. It’s important to list all interest earnings from CDs on your tax return to avoid an unexpected tax bill later.

The amount of taxes you pay on CD interest will depend on several factors, including:

• Your tax bracket: Interest earned on your CD is treated as ordinary income.
• Interest earned: CDs are taxed based on the total interest earned during the tax year.
• Early withdrawal: If you withdrew funds from the CD before it matured and had to pay a penalty, that loss might offset some interest income.
• Type of account: If you opened your CD through a tax-advantaged account, such as an IRA, you won’t pay taxes until you start withdrawing funds in retirement.

When you file your taxes with the IRS, you’ll see a section on your tax form for taxable interest. Make sure to fill out this section with the total dollar amount you earned from CDs and other interest-earning accounts. In addition, you’ll need to attach documentation from your bank regarding your CDs. This form, called a Form 1099-INT, is usually sent to account holders sometime in January.

Frequently asked questions (FAQs)

Additional reporting by Holly Johnson