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What Is a CD?

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A certificate of deposit (CD) is a special type of bank account that enables you to earn a high APY on your savings -- as long as you can leave the money untouched. Below, we explain how it works, the pros and cons, the types of CDs, and how to know if a CD is right for you.

What is a certificate of deposit (CD)?

A certificate of deposit (CD) is a common account type offered by most banks and credit unions, though credit unions often call them share certificates. They're backed by the Federal Deposit Insurance Corporation (FDIC), just like checking and savings accounts, so you're protected up to $250,000 per person per account in case of bank failure.

CDs offer higher APYs than you'll find with most checking accounts and even most savings accounts. It's possible to earn close to 2% APY, especially if you choose a longer CD term, but you must agree not to touch the funds in your CD until the term ends or you'll pay a penalty. More on that below.

How do CDs work?

All CDs have a term, ranging from three months on the short end to more than five years on the long end. Most fall within the six-month to five-year range. During that time, you cannot withdraw your funds without penalty. When you reach the end of the CD term, the CD is considered matured and you may withdraw the funds or place them into a new CD as you see fit. Typically, longer-term CDs offer higher interest rates, but this depends on the bank.

Interest rates are usually locked in for the full length of the CD term, which can be a good or a bad thing, depending on what rates are doing at the time. If rates are decreasing, locking in your CD rate can be a good thing, because it means you can earn a higher interest rate than you with a high-yield savings account, for example, where interest rates can fluctuate. But if you open a CD when rates are rising, you could get stuck earning a lower interest rate.

To combat this risk, some people employ a CD laddering strategy. To do this, you break up the amount you were going to invest in a single CD into chunks and invest them into CDs of differing lengths. For example, you could break up $5,000 into five $1,000 chunks and invest one chunk each in a one-, two-, three-, four-, and five-year CD. When the one-year CD matures, you place that money in a new five-year CD, then do the same thing the next year with the two-year CD, and so on. This enables you to take advantage of higher interest rates on longer-term CDs while still giving you access to some of your money every year.

Interest is usually paid monthly or quarterly, and some banks let you decide if you want the interest paid directly to you or added to the CD. Keeping the money in your CD is your best option if you're trying to earn the most money overall, because when you earn the next interest payment, it'll be on your new, larger balance.

Your CD earnings are taxable, even if you cannot actually spend those earnings yet. Your bank or credit union will send you a 1099-INT form by January 31 of the next year if your CD earned at least $10 in interest during the year. If not, you still owe taxes on the interest, but you are responsible for reporting those earnings yourself.

Once your CD term is up, your bank may choose to place the funds in a new CD automatically if you don't give it other instructions. This is usually a bad option, because the CD the bank chooses might not be the best one for you at the time. So before your CD term is up, you should instruct the bank on what CD you'd like to place your money in, or whether you'd like the money paid to you.

If you withdraw the money before the CD term is up, you will pay a penalty. This penalty is usually equivalent to one or more months of interest, but it depends on the CD you choose and how early you withdraw the funds. Some banks may also impose a minimum penalty. You must withdraw all of the funds in the CD at once -- you cannot leave some there to continue earning interest.


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What are the types of CDs?

There are many types of CDs, and they all work a little differently.

Traditional CD: A traditional CD is the type outlined above. You place money into the account; your interest rate is locked in for the full CD term; and you pay a penalty if you withdraw the funds before the CD has matured.

Jumbo CD: Jumbo CDs work just like traditional CDs, but they tend to have much higher minimum deposit requirements. You can usually open traditional CDs with $5,000 or less, but jumbo CDs usually require at least $50,000 -- some may require $100,000 or more. If you are able to come up with this much cash, you'll be rewarded with a higher interest rate.

No-penalty CD: No-penalty CDs, also called liquid CDs, are CDs that don't charge a penalty if you withdraw funds before the CD term is up. Because there are no consequences for withdrawing funds early, these CDs usually don't have interest rates as high as those of CDs that impose penalties. Look into high-yield savings accounts before investing in a no-penalty CD -- if the rates aren't significantly different, you may prefer a high-yield savings account and its flexibility in accessing your funds.

Bump-up CD: A bump-up CD, also known as a raise-your-rate CD, enables you to request a rate increase at any point during the CD term. It's a good choice if you're worried about CD rates rising over the course of your term. You'll probably be limited in the number of times you can request a rate increase, so you must use them strategically.

Bump-up CDs might start with a lower interest rate than those of comparable traditional CDs. As a result, though you can raise your rate over the CD term, you might end up earning about the same amount with a bump-up CD as you would have with a traditional CD of the same length.

Step-up CD: Step-up CDs are similar to bump-up CDs, except the bank automatically raises your rate at regular intervals if CD rates have increased since you opened yours. If rates haven't risen, your CD rate stays the same. You don't have to worry about your rate decreasing with a step-up CD.

Callable CD: Callable CDs are sort of the opposite of bump-up and step-up CDs. These CDs may have a higher APY to start with, but they carry a big risk. These rates are only locked in for a short time, known as the call protection period. Once this period expires, your bank may "call" the CD away from you at any time and reissue a new CD for the remainder of your term at a lower interest rate.

Banks won't lower your interest rate just for kicks, but if rates have fallen a lot since you opened your callable CD, there's a good chance you'll see your rate drop when the call protection period ends, and earn less in interest overall.

Zero-coupon CD: A zero-coupon CD is a CD you buy at a discount. For example, you might buy a $50,000 CD for $25,000. You don't receive periodic interest payments over the CD term like you do with a traditional CD, but when the CD matures, you get the full face value of the CD. You'll still be responsible for paying taxes on your earnings every year, even if they're not showing up in your account yet. Zero-coupon CDs also tend to require longer terms, so they're not a good fit if you only want to invest your money for a few months or a year or two.

Add-on CD: An add-on CD enables you to make additional deposits into the CD after you open it. Traditional CDs only allow a single deposit. If you want to put more money in a CD, you have to open a new one. But an add-on CD lets you to keep all your money together. Your bank might limit the number of additional deposits you can make, so look into the details before you sign up.

IRA CD: An IRA CD can be any of the other types of CDs, but it's housed inside your IRA. Money in traditional IRAs is usually tax-deferred, so if you keep an IRA CD in one of these accounts, you won't have to worry about paying taxes on your earnings until you withdraw the money in retirement. But if you withdraw funds before the CD term is up, you could pay your CD's penalty plus an early withdrawal penalty from your IRA if you're under 59 1/2.

Brokered CD: A brokered CD is a CD you buy from a brokerage firm. You can sometimes find better rates with brokered CDs, and you can trade them just like you would other investments -- but they also carry greater risk. Not all brokered CDs are FDIC-insured, which means if the bank goes under, you risk losing your money. Plus, if you decide to sell your CD before the maturity date and rates have risen since you purchased it, you might have to take a loss to tempt someone else into buying your lower-earning CD. Brokered CDs can also be callable, which could impact how much you earn in interest.

Foreign currency CD: Foreign currency CDs are based on one or more currencies other than the U.S. dollar. You can make money or lose money, depending on how these currencies fluctuate in value relative to the dollar over the CD term. Once the term ends or you withdraw your money, the CD funds are converted back into U.S. dollars. These CDs are rare, and are not a great investment unless you really understand what you're getting into.

What are the benefits of CDs?

Here are some of the key advantages of a CD:

  • FDIC-insured: CDs are almost always FDIC-insured, so your funds are protected up to $250,000 in the event of bank failure. If you open a CD with a credit union, it may carry NCUA insurance instead, which is essentially FDIC insurance for credit unions.
  • Widely available: CDs are available with most banks and credit unions. This ubiquity means a lot of competition, and that's good news for you. Banks will usually offer the best rates they can to encourage you to choose them over competitors.
  • High APYs: You can earn a higher APY with a CD than you can with most other types of bank accounts, especially if you choose a CD with a longer term.
  • Locked-in rates: This can be good or bad, but when rates are falling, the opportunity to lock in a higher interest rate could help you earn more than if you kept that money in a savings account.

What are the drawbacks of CDs?

Here are a few downsides to CDs you should bear in mind when deciding if this account type is right for you.

  • Penalties for withdrawing money early: When you open a CD, you're tying up your money for months or even years, and you'll pay a penalty if you withdraw your funds early.
  • One-time deposits and withdrawals: You cannot withdraw only part of your CD contributions, and you usually can't deposit more funds into an existing CD unless you choose an add-on CD.
  • Locked-in rates: If interest rates rise after you've opened your CD, you're usually stuck at the lower interest rate for the remainder of the CD term.
  • Taxable earnings even if you can't access them: You still owe taxes on your CD earnings every year, even if you cannot actually spend that money yet.

What are alternatives to CDs?

If you don't think a CD is the right place for your money, here are a few other account types to consider.

High-yield savings account

High-yield savings accounts are usually offered by online banks. They're essentially the same as a regular savings account, except they offer a much higher interest rate, and some of them are comparable to CD rates.

Savings accounts limit you to six monthly transfers or withdrawals, but this is still much more flexible than CDs, which don't permit you to withdraw funds without penalty before the CD matures. You can also deposit money into the account at any time and this won't count toward your limit.

You can withdraw funds electronically or set up automatic bill pay. If your bank has branches, you can visit one to request your money, or use an ATM if your savings account includes an ATM card. Branches and ATM cards are rare with high-yield savings accounts, though, so you may have to transfer your money to a checking account before you can withdraw it.

Money market account

A money market account is similar to a savings account and offers high APYs that can come close to CD APYs. Money market accounts are subject to the same monthly withdrawal limitations as savings accounts, but they often come with checks and debit cards so you can withdraw funds directly from the account when you need them.

Money market accounts usually have higher minimum balance requirements than savings accounts, especially if they offer a high APY, so one of these accounts might be a better fit if you have a large sum to deposit and aren't willing to tie it up in a CD.

Is a CD right for me?

A CD is a smart choice for money you don't expect to need in the next few months or years. You can earn a high interest rate with a CD, but early withdrawal brings a penalty, so it's something you want to avoid. If you're not comfortable risking your savings in the stock market, a CD offers a guaranteed return and a locked-in interest rate for the full term.

CDs aren't a good place for your emergency fund or for money you think you may need to call upon before the CD term is up. Use a savings account or a money market account for these funds instead, so you have easy access to them when you need them.

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