10 Things You Need to Know Before Investing in CDs

Certificates of deposit, or CDs, allow you to lock in an interest rate on your savings for a certain amount of time. This is especially true in the current environment, where CD yields are higher than they've been in years.

However, while the concept of CD yield is well-known by most Americans, there's a lot more to know about this type of bank account that many people aren't familiar with. For example, did you know that some banks require thousands of dollars to open a CD, while others don't? And some CDs might be better for creating an income stream than others.

With that in mind, here are 10 particularly important things to keep in mind as you're deciding whether a CD is the best place to park your cash.

1. You can be penalized for early withdrawals

This isn't exactly a secret, but it's worth mentioning. If you open a CD, your money isn't necessarily locked down at the bank for the entire term -- but you'll pay a penalty if you take it out early. In most cases, the penalty is equal to a few months' worth of interest, and it tends to be worse for long-term CDs than short-term ones.

As an example, an early withdrawal might cost you three months of simple interest, so if you have $10,000 in a CD at a 5% interest rate, pulling your money out early could cost you $125. In certain cases (such as financial hardship) banks may waive CD penalties, but this is rare.

2. There are special CDs that could be appealing

Some banks offer non-standard CD products that might be a good fit for your needs. For example, there are a few banks that offer no-penalty CDs, which allow you to lock in an APY for a certain number of months but won't penalize you if you take your money out early.

There are also step-up CDs (banks may have different names for them) that allow you to adjust your interest rate at any one time during the term. In other words, if you get a step-up CD at a 5% APY and a few months later, the bank is offering a 6% APY on the same CD, you can choose to have your rate reset to the latter.

3. APY is only one part of the equation

If annual percentage yield (APY) was the only factor to consider, choosing a CD would be easy. But it isn't. Also consider the following:

• Does the bank offer other products that you use or are interested in? It can be convenient to keep your financial accounts in one place.
• How often does interest compound on the account?
• How easy is it to manage the account? Does the bank have an excellent mobile app, branches, or other ways to easily get help if you need it?

4. Many banks have minimum deposit requirements

Most online banks have done away with minimum deposit requirements for checking and savings accounts, but many still use them for CDs. The banks on our list of the best CDs have minimum deposit requirements that range from $0 to $2,500, so if you are using a relatively small amount of money to open your first CD, be sure the bank you choose has a minimum that works for you.

5. CDs come in standard term lengths (and some others)

The standard term lengths for CDs are six months, nine months, one year, 18 months, 24 months, three years, four years, and five years. Most banks with CDs offer these terms. Some banks offer non-standard term lengths (say, 13 or 17 months), and in some cases these "promotional" terms are where you can find the highest yields.

You might also be able to find CDs with significantly longer terms. We've found CDs with maturity terms as long as 10 years, and these could be appealing to individuals who want a steady income stream for a long time.

6. Some CDs let you withdraw interest

You can't withdraw the money you deposit into a CD without penalty until it matures. However, some banks allow customers to withdraw the interest income that is paid into the account. Not all banks offer this, but it can make CDs a great tool to create a reliable income stream in retirement.

7. CDs are FDIC insured

As long as a CD is offered by a legitimate financial institution, it receives the same FDIC insurance as a checking or savings account. Money in a CD at an FDIC-insured bank is protected up to $250,000 per person. And if that isn't enough, you can open CDs at different banks to make sure all of your money is safe.

8. CDs automatically renew

You might be surprised to learn that when your CD term expires, the account will automatically renew for another term (usually of the same length) unless you take action. Most CDs have a certain time window prior to expiration where you can choose to not renew, and one week is a common grace period. But if you don't take action, it will renew at whatever the bank's current APY is at the time.

9. CD interest is taxable

One important thing to know is that the interest paid to you by a CD is considered taxable interest income, even if you don't withdraw it. In other words, if you put $10,000 in a 2-year CD at a 5.00% APY, you'll receive $500 in interest income in the first year. And even if you leave it in the account to compound, you can still expect to receive a tax document at the end of the year.

10. You can open CDs in an IRA

As mentioned, CD interest is taxable income. But there's a way around it.

By opening a CD within your individual retirement account, or IRA, you won't pay tax on the interest income you receive each year. If you own your CD in a traditional IRA, you can get a tax deduction for your contribution, but eventual withdrawals from the account will be taxable income. With a Roth IRA, you won't get an initial tax break, but your interest income and eventual withdrawals can be completely tax free.

The bottom line

As you can see, there's more to CDs than simply opening an account, depositing money, and sitting back and collecting interest. CDs can certainly be a great idea for many people, but it's important to know exactly what you're getting into first.