What Is a Certificate of Deposit?

How Does a CD Work?

With a CD, you can expect an interest rate that’s higher than a traditional savings account. They’re available through banks and credit unions, though rates can vary from one financial institution to the next. Here’s an overview of how a CD generally works:

• Term: The term is how long it takes for a CD to mature after you make the opening deposit. Terms commonly range from three months to five years.
• Interest: Interest rates on CDs are usually several points higher than the federal funds rate. That allows your money to earn more than it would in a traditional savings account. Rates are generally fixed for the duration of the CD term.
• Opening deposit: This is the money you put into a CD at the start of its term. Most CDs don’t allow you to contribute more funds once the account has been opened. A typical minimum deposit is $500 to $2,500 or more.
• Early withdrawal penalty: Most CDs charge a fee if you withdraw money before the term ends. Early withdrawal penalties vary based on the financial institution, term length and size of the withdrawal. The fee can range anywhere from 60 to 540 days’ worth of interest.

Types of CDs

Here’s a closer look at the many different types of CDs.

Traditional CD

A traditional CD, or standard CD, has a set interest rate and fixed term that typically ranges anywhere from three months to five years. Longer terms often translate to higher yields. If rates rise while your money is locked into a traditional CD, that could diminish your returns. Keep in mind that tapping your funds early will likely result in a fee. In this way, it’s possible to lose money with a CD.

High-Yield CD

A high-yield CD works like a traditional CD. The main difference is that it offers a higher interest rate than other CDs and savings accounts. According to the Federal Deposit Insurance Corp. (FDIC), the average rate on a traditional savings account is 0.42%. Traditional CDs range anywhere from 0.20% to 1.37%, depending on the term length. Some high-yield CDs currently have rates well over 5%. However, the minimum opening deposit may also be higher. Some high-yield CDs require $5,000 or more.

Bump-Up CD

CDs typically have a locked-in interest rate. That can work in your favor if rates fall during your maturity period. But you could miss out on better returns if rates go up. Bump-up CDs allow you to increase your rate to the current market rate. You can usually only do this once, though some long-term CDs may allow multiple adjustments. The trade-off is that bump-up CDs generally offer lower initial rates than fixed-rate CDs.

Step-Up CD

Whereas a bump-up CD usually allows for one rate adjustment that you have to request, a step-up CD automatically increases the rate at scheduled intervals throughout the term. That might be every six or 12 months. However, the initial interest rate on a step-up CD is typically on the lower side.

Liquid CD

CDs aren’t known for their liquidity. If you need to access your money before the maturity date, you’ll likely be hit with a fee. A liquid CD, also known as a no-penalty CD, allows you to withdraw money before the term ends, free of charge. However, interest rates on liquid CDs tend to be lower than other types of CDs.

Jumbo CD

These types of CDs offer higher interest rates than traditional CDs, but the required minimum deposit is much higher—usually $100,000 or more. This allows account holders to earn much more on their investment. Rates are fixed, and you’ll likely incur a penalty if you withdraw funds prior to the maturity date.

IRA CD

You can open an IRA CD through an individual retirement account (IRA). It’s essentially a CD that’s invested for retirement. This strategy offers the high yield of a CD and the tax perks of an IRA. You can roll money over from an existing IRA or fund it with new contributions. If you opt for the latter, you can kick in up to $6,500 in 2023 (or $7,500 if you’re 50 or older).

CD vs. Savings Account

Both CDs and savings accounts are interest-earning deposit accounts. They’re considered stable, low-risk investments, but they’re structured a little differently. Like CDs, high-yield savings accounts offer above-average interest rates—but they don’t require you to give up access to your funds.

That liquidity is what makes a high-yield savings account an ideal home for your emergency fund. A CD, on the other hand, is better suited for money you don’t plan on spending in the near future. Both types of accounts can help you grow your wealth over the long run.

Pros and Cons of a CD

Like any other financial product, CDs have benefits and drawbacks.

Pros

• They’re safe investments. Returns may be modest, depending on the interest rate, but they’re also guaranteed. CDs provide a level of predictability that can be appealing to risk-averse investors.
• They help with diversification. Holding a variety of investments across different asset classes can help mitigate risk. If you’re only invested in the stock market, what will happen to your portfolio if there’s a market downturn? CDs keep some of your wealth out of the stock market while still earning a return.
• Rates are typically higher than a traditional savings account. In addition, some CDs provide higher interest rates than high-yield savings accounts. If you have a large opening deposit, a jumbo CD can help maximize your earnings.

Cons

• Your money is locked into the CD. Most CDs require you to part with your money for a predetermined amount of time. If you make a withdrawal before the term ends, you’ll probably face a penalty.
• There may be a minimum opening deposit. Some CDs have hefty opening deposit requirements. If you see an advertised rate that seems too good to be true, be sure to read the fine print.
• You might get better returns elsewhere. Over the past century, average annual returns for the stock market have come in at around 10%. While returns are never guaranteed, you’ll be hard-pressed to find a CD with that kind of interest rate. Consider diversifying your portfolio with a mix of different assets to balance risk with potential returns.

How Are CD Rates Determined?

CD interest rates vary depending on the financial institution and CD term. That’s why it’s smart to shop around and compare CDs before making a decision. In general, the federal funds rate plays an important part. This is the interest rate that’s set by the Federal Reserve. Financial intuitions use it as a benchmark when setting their own lending rates and annual percentage yields (APYs). When the federal funds rate goes up, interest rates on loans and savings accounts tend to do the same. The opposite is also true.

Are CDs Worth It?

You’ll want to evaluate your overall financial health to see if CDs are worth it. Here are some instances when CDs make financial sense:

• You’re looking to diversify your portfolio with safe, stable investments.
• You want to lock in a good rate before interest rates potentially drop.
• You have a chunk of money you don’t need right now.
• You want to keep some of your money out of sight so you won’t be tempted to spend it.
• You don’t have high-interest debt.

Are CDs Safe?

These low-risk investments are seen as very safe. CDs provided by FDIC-insured banks are covered for up to $250,000 per depositor. If you open a CD at a credit union, you’ll get similar coverage through the National Credit Union Administration (NCUA). Spreading your CDs across multiple financial intuitions can help protect your wealth if a bank or credit union fails.

How Are CDs Taxed?

Interest you earn through savings accounts and most CDs are taxed as ordinary income. An exception is an IRA CD, which has special tax advantages. CDs are taxed differently than earnings from stocks, exchange-traded funds (ETFs) and mutual funds. These are subject to capital gains tax, which is usually lower than regular income taxes. If you earn interest from a CD, your financial institution should send you a 1099-INT statement with the details. You’ll need to include this information on your tax return.

How to Open a CD

You can take the following steps to open a CD:

• Choose the right type of CD for you. Review the different types of CDs mentioned earlier and decide which one is most compatible with your financial plan.
• Shop around. Look at different financial institutions and compare interest rates, terms, minimum opening deposits and fees.
• Open and fund your CD. Opening a CD is pretty straightforward and can be done online, in person or by phone. You can then make your initial deposit, ride out the term and receive your interest payment.

What Is a CD Ladder?

CD laddering is an investment strategy that involves opening multiple CDs that have different term lengths. The idea is to stagger them so they provide a stream of interest payments as each one expires. You’ll also get back your initial deposit at the end of each term. You can reinvest that money into another CD or use it to fund short-term financial goals like:

• Buying a home
• Completing a home renovation
• Purchasing a car
• Going on vacation
• Funding your child’s education
• Starting a business

What Happens When a CD Matures?

You have options when a CD matures. You’ll have a short window of time when you can:

• Roll your funds into a new CD.
• Change your CD term or add money to your CD before renewing it.
• Cash out and do something else with your money.

You probably won’t have much time to decide. Some financial institutions will automatically renew your CD if you don’t take action within seven to 10 days. Others will simply cut you a check for the balance.

The Bottom Line

Some CDs offer competitive interest rates and allow your money to work a little harder for you. Gains tend to be modest, but CDs can help diversify your investment portfolio and provide reliable returns you can count on.

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