What Is a Certificate of Deposit (CD)? Pros and Cons

What Is a Certificate of Deposit (CD)?

A certificate of deposit (CD) is a type of savings account that pays a fixed interest rate on money held for an agreed-upon period of time. CD rates are usually higher than savings accounts, but you lose withdrawal flexibility. If you withdraw your CD funds early, you'll be charged a penalty.

CDs come in a variety of terms from 3-, 6-, or 12-months to 4-, 5-, and even 10-year terms. Learn more about how CDs work and about the advantages and disadvantages.

How Certificates of Deposit (CDs) Work

Opening a CD is similar to opening any standard bank deposit account. When you shop around, consider these factors:

1. Interest rate: Most CD interest rates are fixed, though there are variable-rate CDs that could earn a higher return if rates rise. With a fixed-rate CD, you'll know exactly how much you'll earn by the end of the term, but it could hurt you if rates rise after you're locked in.
2. Term: This is the length of time that you agree to leave your funds deposited to avoid any penalty (for example, 6-month CDs, 1-year CDs, 18-month CDs, etc.) The term ends on the maturity date, when your CD has fully matured and you can withdraw your funds penalty-free.
3. Principal: With the exception of some specialty CDs, this is the amount that you agree to deposit when you open the CD.
4. Financial institution: The bank or credit union where you open your CD will set factors such as early withdrawal penalties (EWPs) and whether your CD will default to being automatically reinvested at the time of maturity.

You'll get either monthly or quarterly statement periods, paper or electronic statements. Monthly or quarterly interest payments will be deposited to your CD balance and the interest will compound. 

Why Should I Open a CD?

Unlike most other investments, CDs offer fixed interest rates that are often higher than the rates on other bank accounts. Generally, the longer the terms, the higher the rates.

CDs are an attractive option for savers who want to earn more than most savings, checking, or money market accounts without taking on more risk.

CDs vs. Savings and Money Market Accounts

CDs are like savings or money market accounts in that they allow you to put money away for a set period. That way you can save toward a specific goal like a down payment on a house, a new car, or a vacation. Or, you may want to use a CD as an emergency fund that earns a guaranteed return.

Savings and money market accounts allow you to make additional deposits as well as withdrawals. But with CDs, you make one initial deposit that stays in the account until its maturity date. In return for giving up access to your funds, CDs generally pay higher interest rates than savings or money market accounts.

How Are CD Rates Determined?

The Federal Reserve’s rates play a large role in what you earn on your deposits. That’s because the Fed’s decisions can directly affect a bank’s costs. Here’s how it works.

Every six to eight weeks, the Federal Open Market Committee (FOMC) decides whether to raise, lower, or hold the federal funds rate. This rate is the interest that banks pay to borrow and lend their excess reserves to each overnight through the Fed.

This benchmark rate influences what banks and credit unions are, in turn, willing to pay consumers for their deposits in savings, money market, and CD accounts. The higher the federal funds rate, the more interest you can earn on a CD.

Interest Rate Trends

In December 2008, the Fed reduced its rate to the lowest level possible of essentially zero as a stimulus to lift the U.S. economy out of the Great Recession. It left rates anchored there for a full seven years. During that time, deposit rates of all kinds—savings, money market, and CDs—tanked. The Fed did the same in 2020.

In 2022, amid record-setting inflation, the Fed aggressively raised interest rates. Between 2021 and 2023, average CD rates tripled or quadrupled, depending on the term.

Each bank determines how much interest it will pay on CDs. If a bank may need more deposits to fund loans, it may be more aggressive in trying to attract deposits. A large bank with sufficient deposit reserves may be less interested in growing its CD portfolio and offer lower rates.

Are CDs Safe?

CDs are one of the safest ways to invest your money. First, their rate is fixed and guaranteed. Second, CD investments are protected by the same federal insurance that covers all deposit products.

The Federal Deposit Insurance Corp. (FDIC) insures bank accounts, and the National Credit Union Administration (NCUA) insures credit union accounts. In both cases, up to $250,000 of your funds are protected in the rare event that institution were to fail.

When Is Opening a CD a Good Idea?

CDs can be a good idea in several situations. A CD may be a good option if you have cash that you don’t need now, but that you will want within a few years. Investing in a CD can help you save for a vacation, a new home, or a car.

A CD may be a good idea if you want some of your savings invested conservatively. It can help you achieve lower risk and volatility than investing in the stock and bond markets.

One of the downsides of CDs is that your money is locked into the investment. However, that can be a benefit for some savers who worry that they will be tempted to withdraw from their savings. The fixed term of a CD and the penalty for early withdrawal provide a deterrent to spending.

Where Can I Get a CD?

Most banks and credit unions offer at least one CD with a wide array of terms. This includes, large banks, smaller banks, and online banks. In addition, you can open CDs through your brokerage account.

Find the Best CD Rates

With the growth of online banking, you can shop for CDs at hundreds of banks and credit unions, including those that allow you to open an account online. In addition, you’ll have access to a number of regional and state banks and credit unions based on your residency.

CD rates can vary widely. Shop for options available everywhere, not just at your current bank. Leverage online tools to aid in your search.

How Much Do I Need to Open a CD?

Each bank and credit union establishes a minimum deposit required to open a CD. Sometimes a bank will set a minimum deposit policy across all CDs. Some offer rate tiers with a higher annual percentage yield (APY) if you have higher minimum deposits.

In theory, a greater deposit will earn you a higher return. In practice, this doesn’t always hold true. Many of the top 10 rates in each CD term can be achieved with modest investments of just $500 or $1,000. And the majority of top rates are available to anyone with at least $10,000. A $25,000 deposit is only occasionally required for a top rate.

Which CD Term Should I Choose?

You'll need to determine the CD term that is right for you.

Consider your plans for the money. If it’s for a specific goal or project, the expected start of that project will help you determine your ideal CD term length. If you’re just socking away cash with no particular goal, you may opt for a longer term and higher interest rate.

Also consider what’s expected to happen with the Fed’s rate. If it’s anticipated that the Fed will raise rates—and bank and credit union CD rates will likely rise as well—then short- and mid-term CDs will make more sense than long-term CDs. That's because since you won’t want to be committed to a lesser rate for five years when new, higher rates appear.

Conversely, if you expect rates will decrease in the near term, you may want long-term CDs, so you can lock in today’s higher rates for years.

One other way to invest in CDs when interest rates are rising is to buy a variable rate CD or a bump-up CD. A variable rate CD has an APY that changes based on an index rate—it can go up or down.

Essentially, you should aim buy a variable-rate CD when rates are expected to go up and stay up. A bump-up CD allows you to increase the rate at one time of your choosing, and the rate can not go down.

A CD Ladder: Why Should I Build One?

A CD ladder enables you to access the higher rates offered by 5-year CD terms. The twist is that a portion of your money becomes available every year rather than every five years. Here’s how to build a CD ladder.

At the outset, you take the amount of money that you want to invest in CDs and divide it by the number of CDs you will invest in. Let's say you will invest in five CDs. You then put one-fifth of the funds into a top-earning 1-year CD, another fifth into a top 2-year CD, another into a 3-year CD, and so forth through a 5-year CD. Let’s say you have $25,000 available. That would give you five CDs of varying length, each with a value of $5,000. 

Then, when the first CD matures in a year, you take the resulting funds and open a top-rate 5-year CD. A year later, your initial 2-year CD will mature, and you’ll invest those funds into another 5-year CD.

You continue doing this every year with whichever CD is maturing until you end up with a portfolio of five CDs all earning 5-year APYs, but with one of them maturing every 12 months.

How Are CD Earnings Taxed?

When you hold a CD, the bank will apply interest to your account at regular intervals. This is usually done either monthly or quarterly and will show up on your statements as earned interest.

Just like interest paid on a savings or money market account, interest will accumulate and be reported to you in the new year as interest earned. Then, you report it as income when you file your tax return.

What Happens to My CD at Maturity?

Leading up to your CD’s maturity date, the bank or credit union will notify you of the impending end date. You will receive instructions on how to instruct the bank with what to do with the maturing funds.

Typically, they will offer you three options.

1. Roll over the CD into a new CD: Generally, it would be into a CD that most closely matches the term of your maturing CD. For example, if you have a 1-year CD, it would likely roll into a new 1-year CD.
2. Transfer the funds into another account: Options include savings, checking, or money market account.
3. Withdraw the proceeds: Proceeds can be transferred to an external bank account or mailed to you as a paper check.

In many cases, the bank will default to rolling your proceeds into a new CD.

What If I Need to Withdraw My Money Early?

Even though opening a CD involves agreeing to keep the funds on deposit without withdrawals for the duration of the term, that doesn’t mean you lack options if your plans need to change.

Whether you encounter an emergency or a change in your financial situation—or you simply feel that you can use the money more usefully or lucratively elsewhere—all banks and credit unions have stipulated terms for how to cash your CD out early.

The exit won’t be free, of course. The most common way that financial institutions accommodate a premature termination is by assessing an early withdrawal penalty (EWP) on the proceeds before your funds are distributed, according to specific terms and calculations that were set out in your deposit agreement when you first opened the certificate. This means that you can know before you agree to the CD if the EWP is acceptable to you.

Most typically, the EWP is charged as a number of months’ interest, with a greater number of months for longer CD terms and fewer months for shorter CDs. For instance, a bank’s policy might be to deduct three months’ interest for all CDs with terms up to 12 months, six months’ interest for those with terms up to three years, and a full year’s worth of interest for its long-term CDs. These are just examples, of course—every bank and credit union sets its own EWP, so it’s important to compare EWP policies whenever you are deciding between two similar CDs.

It’s especially wise to watch out for EWPs that can eat into your principal. The typical EWP policy described above will only cause you to earn less than you would have if you had kept the CD to maturity. You will generally still have earnings, as the EWP will usually only eat up a portion of your earned interest.

But some particularly onerous penalties exist in the marketplace, where a flat-percentage penalty is applied. Since this percentage can outweigh what you’ve earned on a CD that you haven’t kept very long, you could find yourself collecting less in proceeds than you invested. As a result, these EWP types are best avoided.

Frequently Asked Questions (FAQs)

The Bottom Line

Certificates of deposit offer stability for people who want to earn more on their money without the risk inherent in stocks and bonds. Although interest rates may be higher than savings accounts and money markets, read the fine print carefully.

Tying up your money for long set terms may be safe, but you may lose out on higher interest returns if the federal funds rate increases. While you may be able to withdraw your money early, there will be penalties, some of which can cut into your principal. Know the limitations and benefits of any investment.