What Is a Certificate of Deposit and How Does It Work?

A certificate of deposit (CD) is a time-deposit savings account that earns interest for a predesignated period of time. When learning how CDs work, know that CDs have term periods between 21 days and 10 years. The longer the term, the higher the interest rate. You won’t be able to withdraw your funds until the term period ends (maturity date).

What Is a Certificate of Deposit?

A certificate of deposit is a savings product issued by banks, credit unions, and brokerage firms. CD issuers pay a steady annual percentage yield (APY) on the deposited amount for a set period of time. In most cases, this principal amount cannot be withdrawn without paying a penalty fee. Once the CD account reaches maturity, you can access the funds or choose to roll it over into another CD of the same term length.

CDs are best for savers looking to earn interest and who won’t need regular access to those funds. Since certificates of deposit are low-risk options, you can access your principal deposit with interest on the date the CD matures. Certificates of deposit are available to both consumers and businesses. These accounts tend to have higher interest rates than even the best business savings accounts. The best CD for you will often depend on the CD rates and terms.

How CDs Work

Once you open a CD account, you won’t be able to access those funds until the end of the term period, otherwise known as the maturity date. When a CD matures, you have the option to withdraw your funds in total or roll it over into another certificate of deposit. CD term periods can be as short as 21 days and as long as 10 years. If you don’t withdraw the funds after maturity, the bank will automatically renew your CD for the same term.

Consumers who withdraw funds from a CD before the maturity date, can face 12 months or more of interest earned in penalty fees, commonly called an early withdrawal penalty. They are insured up to $250,000 for individual accounts, and up to $500,000 for joint accounts, under the Federal Deposit Insurance Corporation (FDIC). Most CDs through credit unions are insured up to the same amount with the National Credit Union Association (NCUA)—the credit union’s equivalent to the FDIC.

How CDs Work: The Federal Reserve

The Federal Reserve determines the national prime rate, which impacts the rates banks set on savings accounts and CDs. When the Federal Reserve cuts its benchmark rate, CD issuers may drop the annual percentage yield (APY) they offer on interest-bearing accounts. Locking in a long-term CD when rates are low could potentially mean missing out on a higher APY when rates rise again.

How CDs Work: CD Laddering

CD laddering is a method some people use when they still want the high yield interest rate of a CD, but with access to funds at shorter intervals of time. Instead of getting one long-term CD, you can get multiple CDs that have different term lengths in order to access funds at various times without paying a withdrawal fee. This method also allows account holders to renew shorter-term CDs at higher rates.

How CDs Work: Credit Reports

Like with any new account, there’s a possibility that your CD issuer will need to pull your credit report. If you already have an existing relationship with a CD issuer, they may not need to pull your credit report. Most credit inquiries occur when the bank or credit union needs to verify your identity, which isn’t necessary if you already have a checking or savings account.

There are some cases where the bank will need more information and may make a hard inquiry on your credit report, which could temporarily lower your credit score. It’s important to ask your bank about the credit qualification process before opening a certificate of deposit.

Who a Certificate of Deposit Is Right For

A certificate of deposit is best for anyone looking to earn higher interest rates on their money, but who don’t need immediate access to the funds. CDs typically pay higher interest rates than traditional savings accounts and are a lower-risk option compared to investment accounts. They’re also great for people with a specific financial goal in mind, like a vacation or college tuition.

CDs are best for:

• Earning more interest: CDs earn APYs that are typically higher than traditional savings and most money market savings accounts. Generally, the longer the CD term, the higher the APY. CDs typically earn an APY of 0.75% or more for a five-year CD, depending on the bank.
• Opening a protected savings account: People who don’t need access to funds right away can get a CD with a term as long as 10 years. It’s easier to meet your savings goals when the funds aren’t easily accessible for withdrawals, allowing your deposit to continue to earn interest, untouched.
• A low-risk investment: CD accounts are considered a safe and low-risk investment option because they are usually FDIC or NCUA insured in case the issuer fails or goes out of business.
• Locking in a higher interest rate: Fixed-rate CDs are an opportunity to lock-in high interest for the entire term of the CD, without the worry of falling interest rates.
• Saving money for your business: CDs are also available in business accounts. Business owners who need to save money with higher rates than savings can do so with a certificate of deposit.

Consumers looking to save money can open a CD where they already bank. CDs are readily available at most banks, credit unions and brokerage firms. Since the funds will be locked-away for a period of time, you’re more likely to meet your savings goals. However, those looking for the best rates should shop around online to compare prices.

Types of Certificate of Deposits

Traditional CDs are a safe way for many people to earn higher interest rates on their money while having a guaranteed long-term interest rate. There are different kinds of certificates of deposit accounts with a variety of term lengths, interest rates, and requirements after maturity.

Traditional CD

The standard certificate of deposit account has a range of term periods with interest rates that are usually higher than money market savings and traditional savings accounts. These CDs are available at most banks and credit unions in a variety of term lengths, as much as five to 10 years. However, many issuers offer CDs with a maximum term of only five years. Minimum deposits are usually as low as $500 or less.

A traditional CD locks in your interest for the entire time of the agreement term. Your interest will be paid to you monthly, once per year, or at the end of your term, depending on the bank. Most issuers give you the option to choose whether to have interest accumulate on the CD, or be paid incrementally to your checking or savings account. Like most CDs, you won’t be able to access the principal amount before the maturity date without paying an early withdrawal penalty equal to the term length in interest.

IRA CD

An IRA CD is similar to a traditional CD, except that you use money from your IRA account to fund it. The benefit of having an IRA CD is that they come with certain tax privileges and taxes may be deferred in most cases. Unlike market investments, you can count on steady returns, plus your funds are FDIC-insured up to $250,000. However, yearly IRA income contribution limitations and restrictions still apply.

Variable-rate CD

Variable-rate CDs are different from traditional CDs because they allow you or the bank to change your interest rate before its maturity date. Some people may choose this option if they don’t want to miss out on a future rate increase. Others might choose an adjustable-rate CD in order to get a higher initial interest rate and risk the decreased interest later.

The two types of variable-rate CDs are:

• Bump-up CD: Allows customers to choose when they want to increase their interest rate in case interest increases later on. Most bump-up CDs limit account holders to only one or two raises per term.
• Flex CD: Allows the bank to adjust the interest, either up or down, after a preset fixed-rate period. It’s also known as a step-down or step-up CD.

Flex CDs typically have a fixed-rate period of one year before the interest rate is automatically adjusted. These adjustments are usually based on the Federal Reserve’s benchmark rates and are decided by the issuing institution. Bump-up CDs typically allow account holders to choose when they want to increase their interest rate. However, those CDs tend to have lower initial APYs than traditional CDs because of this flexibility.

No-Penalty CD

No-penalty CDs allow account holders to withdraw funds before the maturity date without any penalty fees. It’s similar to a savings account because you have access to your funds anytime. However, in order to withdraw funds, the entire amount must be reclaimed and the CD account closed. That means you might miss out on higher returns after account closure. Consumers would need to open a new CD account to earn interest again.

High-yield CD

High-yield CDs offer higher APY than regular CDs. They also usually require higher minimum balances than traditional CDs. Online banks tend to have the highest CD rates offering the bulk of the high-yield CDs. High-yield CDs are best for people saving for long-term goals, like college intuition or home repairs. These CDs also have locked-in rates and you won’t have access to funds without paying a steep penalty fee of up to 12 months of interest or more.

Foreign Currency CD

A foreign currency CD is an account that’s purchased in a different country’s currency. These accounts can potentially yield higher interest rates and payouts than US currency CDs. However, because these CDs are not FDIC-insured, they are higher-risk investments than US based certificates of deposit accounts. Account holders could risk their entire deposits with little-to-no recourse available.

Callable CD

Callable CDs earn a guaranteed fixed rate of interest up through the preset “call” date, after which, the bank can redeem your CD amount in full before it matures. For example, you can have a CD term for two years but have a “callable” date of six months. That means in six months, and every six months after, the bank has the opportunity to close the CD before the two-year maturity date. Brokerage firms commonly offer these CDs.

Consumers run the risk of missing out on interest they would have otherwise earned if it was allowed to mature. Not to mention, to reinvest would mean possibly locking in a lower APY. Because of this, issuers usually reward consumers with a higher initial interest rate. If the bank chooses to “call” your CD, you will still receive the principal and any interest earned up to that date.

Liquid CD

Like no-penalty CDs, liquid CDs allow consumers to withdraw CD funds before its maturity date without a penalty fee. However, with a liquid CD, consumers don’t have to close the CD account to access funds. As a result, these CDs tend to have lower interest rates than traditional CDs. They may also require you keep a minimum balance and restrict the number of times you can withdraw funds, including an initial waiting period.

Brokered CD

Brokered CDs are certificates of deposit accounts that brokerage firms offer. These CDs have a collection of banks competing for investors who are looking to purchase CD accounts. Because brokerage firms have access to multiple banks, they can pool a variety of bank CDs to get a higher APY and bigger investment returns. Although, these CDs may come with additional investment and trading fees.

Jumbo CD

Jumbo CDs are large-denomination negotiable CDs. They usually have a minimum requirement of at least $100,000 and are typically purchased by large banks and institutions. Some pension funds also acquire jumbo CDs for their investors. The most common term lengths for jumbo CDs include one-two-three- and five-year terms.

Zero-coupon CD

Instead of interest being paid out to the account holder on a regular basis (semi-annually or yearly), zero-coupon CDs apply the interest account holders earn back into the principal amount. This allows for compounded interest and higher returns later on. However, similar to traditional CDs, account holders are still required to pay taxes on the interest they earn even though it isn’t being paid out.

Certificate of Deposit Rates & Costs

Maturity dates for CDs typically vary and term lengths can range from 21 days to 10 years. Although term lengths vary, the most common term lengths are six, 12, 18, 24, 36, 48 and 60 months. In most cases, you’ll need an existing relationship with a bank to open a CD account, however, not all CD issuers require this.

Most Common CD Rates

Certificate of Deposit Account Fees

How CDs work in terms of cost is usually dependent on how much the issuer charges for early withdrawals. Consumers who choose to close or withdraw funds from a CD account before the maturity date will incur penalty fees. These fees are based on the term length of your CD and are often applied in the form of interest you did, or would have earned up through the date of withdrawal or maturity.

Common early withdrawal fees are:

• Three month term or less: 30 days of interest, all interest earned, or seven days of interest, whichever is greater
• Three to 12 month term: Three months of interest
• 12 to 24 month term: Three to six months of interest
• 24 to 60 month term: Three months to one year interest
• Over 60 month term: Three months to one year’s interest

Specialty CDs, like IRA CDs, may charge a transfer fee as much as $50 for moving funds to a different bank. However, some banks, like Chase, charge a percentage of the total amount withdrawn. That can add up to 1% to 2% of the amount, depending on the term length. You may also incur an additional one-time fee of up to $25 or more, depending on the CD issuer.

Certificate of Deposit Providers

The most common place to get a certificate of deposit is from a bank or credit union. Brokerage firms also offer CD accounts that are FDIC-insured, which is a plus for conservative investors. You can apply for a CD account in-person or online.

1. Banks

Banks are the most common place to open CDs. Most consumers who already have a deposit relationship can easily open a CD by transferring funds from their existing bank account. Bank CDs offer FDIC-insured accounts that guarantee you will get your money back in case the bank fails. Some banks, like Chase and Wells Fargo, reward customers that keep a minimum balance with higher CD interest rates. You can open a CD account online or in person.

2. Credit Unions

Certificates of deposit accounts are readily available at credit unions and they typically offer higher interest rates on CDs than banks. Credit union CDs are also insured up to $250,000 by the NCUA. However, it’s typical for credit unions to have specific membership requirements in order to join, like residency in a specific community or working for a sponsored company. You can open most credit union CDs online or in person.

3. Brokerage Firms

Brokered CDs are obtained through a brokerage firm and are also FDIC-insured. Because a brokerage firm can purchase CDs from multiple banks you can potentially have FDIC coverage for more than just the $250,000 per bank limit. Brokered CDs also have multiple banks that compete for accounts, so the rates are competitive. However, you may have to pay additional brokerage fees. You can open a brokered CD account online or in person.

Pros & Cons of Having A Certificate of Deposit

CDs can be a great way to get a return on your savings funds, but there are some drawbacks as well. CDs have guaranteed interest rates, but they can be lower than other higher-risk accounts like investment accounts. Understanding how CDs work, some consumers may consider a savings account instead.

Pros of Having A Certificate of Deposit

• Pay high interest rates: Consumers that have a deposit relationship with a bank can earn even higher interest rates. Most CDs offer fixed-rates and you are guaranteed that rate until the term ends. CDs typically offer higher interest rates than traditional savings accounts. CD accounts can earn up to 1% to 2% more in APY.
• Low-risk investments: CDs are lower risk because the APY is locked in for the period of the term. You don’t risk losing your principal deposit unlike with investment accounts.
• FDIC-insured: Your deposit is protected for up to $250,000 in case the bank goes out of business or fails. Most credit union CDs are insured up to $250,00 with the NCUA.

Cons of Having A Certificate of Deposit

• Less flexibility: CDs come in time-locked terms and you may not have access to the funds until it matures. Term lengths can be as long as 10 years.
• Potential penalty fees: Most CDs charge early withdrawal fees when you withdraw money before the maturity date. Penalty fees for early withdrawals can cost up to 2% of the withdrawal amount, which can affect your principal amount.
• Some CDs have lower interest rates: Some CDs, like the no-penalty CD, allow account holders access to funds before the maturity date without any fees. However, those CDs offer lower interest rates than even standard CDs.

Certificate of Deposit Frequently Asked Questions (FAQs)

We covered a lot of information regarding certificates of deposit, what they are, and who they are best for. There are some questions that are asked more often than others, and we address those here. If you have any questions, please leave a comment below and one of our experts will respond.

What is a certificate of deposit and how does it work?

A certificate of deposit is an account that allows you to earn interest and access your funds after a specific period of time. CDs earn a set interest rate and deposited funds are available after the maturity date. CD terms lengths can run from 21 days to as much as 10 years.

Can you lose your money in a CD?

When you place funds in an FDIC-insured CD, you will not lose your principal amount or the interest you earned, up to $250,000. If you remove the funds before the end of the term or maturity date, you will incur penalty fees equal to or more than portion of the interest you’ve earned, which can reduce your principal amount.

Do you have to pay taxes on a CD when it matures?

Funds that you deposit into a CD are, in most cases, not taxable. However, the interest that you earn on the CD during the term is considered taxable income. In some cases, like with IRA CDs, the interest you earn may not be taxable. Check with your CD issuer to confirm your account’s policies.

Bottom Line

A certificate of deposit account is a great opportunity to earn interest on your savings. How CDs work will depend on the type of CD and term length. The most common CD terms are six, 12, 18, 24, 36, 48, and 60 months. Although some CDs offer more flexibility than others, they may offer lower interest rates. Either way, you can use CDs to lock away funds and meet your long-term and short-term financial goals.