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How do certificates of deposit work? Understanding CDs — including 7 types for boosting your savings

Kat Aoki
Updated
How do certificates of deposit work? (Flashvector via Getty Images)

A certificate of deposit — or CD — is a type of deposit account that allows you to grow your savings at higher rates than a traditional savings account. Offered by big-name and digital banks, credit unions and financial services companies, CDs let you lock in competitive rates of up to 5.00% APY or more on your deposit with guaranteed returns and virtually no risk. This makes them ideal for achieving financial goals like building an emergency fund, planning for retirement or saving for a major purchase.

Here’s a closer look at how CDs work, the different types available and how to open one.

A CD is a deposit account that provides a guaranteed fixed annual percentage yield — or APY — in exchange for locking up your money for a set amount of time, anywhere from three months to five years. Deposits and interest earned within a CD’s term are protected by the Federal Deposit Insurance Corporation (FDIC) or National Credit Union Administration (NCUA) for up to $250,000 per account and per bank. (Note that at credit unions, CDs are called share certificates.)

The yield that you can earn on a CD depends on the provider and the term, with digital banks offering some of the highest APYs available. Yet while CDs offer high yields, they differ from high-yield savings accounts and other investments in a few key ways.

Due to their fixed terms and low deposit requirements, CDs can offer significantly higher interest rates when compared to traditional savings and checking accounts — up to 10 times more than the average 0.45% on a traditional savings account.

With the Federal Reserve holding off on interest rate cuts, the best high-yield savings accounts offer similarly competitive rates as CDs right now. But unlike high-yield accounts that come with variable rates — rates that can increase or decrease with the market — CDs offer a guaranteed APY that’s fixed over the life of your CD’s term,

CD terms can range from three months to 10 years, during which time you typically can’t withdraw your money without incurring a fee. It means that you can predict exactly how much you’ll have earned by the time your CD matures — or expires.

Historically, banks were willing to extend higher APYs in exchange for you leaving your cash untouched for longer terms. Today, the most competitive rates are on shorter terms of up to 12 months.

Unlike savings and checking accounts that allow you to withdraw funds at any time, if you withdraw money from your CD before it matures, you typically face an early withdrawal penalty that’s equivalent to three to 12 months’ worth of interest, depending on the CD’s term.

No-penalty CDs are an exception, although there may be limitations on how soon you can withdraw your funds after opening a no-penalty CD.

Be sure to read over your CD’s agreement before depositing funds to make sure you understand what it could cost you if you break your CD — and whether it could be worth it to get access to your money or take advantage of higher rates elsewhere.

When your certificate of deposit reaches maturity, many banks will automatically reinvest your funds into a new CD with the same term — but at a possibly lower rate — if you don’t take action during the grace period. The grace period is like breathing room a bank extends to give you time to decide what to do with your money, typically seven to 10 calendar days after your CD matures.

You can avoid reinvestment by providing instructions to your bank before the grace period ends, such as cashing out your account balance or transferring your money to a different type of account, like a high-yield savings account.

Some CDs require a minimum deposit that can vary from a few hundred to several thousand dollars, depending on the institution and the product. However, this isn’t true across the board.

For example, Capital One offers CDs with no minimum deposit requirement, making them accessible to anyone who wants to open a CD to achieve a variety of savings goals.

Unlike a savings account, most CDs allow only one initial principal deposit, preventing you from making additional deposits during the term.

But again, there are exceptions, with some banks allowing additional limited deposits during a CD’s term. The 15-month Flex CD from Climate First Bank is one example, allowing you to add additional deposits to the CD in $100 increments, up to half of the initial principal balance.

Learn more: High-yield savings account vs. CD: What to know when rates are high

Most CDs offer fixed rates, with an APY that represents the total amount of interest you’ll earn over a year, accounting for interest compounding. Compounding is when the interest earned on your deposit is added back to your CD’s principal, allowing you to earn interest on your interest.

Most CDs compound interest daily or monthly. For short-term CDs of under 12 months, the APY is often very close to the stated interest rate because the effect of compounding is negligible over such a short period. But the more frequently interest is compounded, the higher the effective yield will be — with the difference more significant the bigger your deposit and the longer your term.

The interest you earn on a CD is considered taxable income by the IRS, just like interest earned on other savings accounts. If you earn more than $10 in interest in a calendar year, your bank or financial institution will send you a Form 1099 to file with your annual tax return.

You might be able to defer taxes on your earned interest if you open a CD as part of a retirement account, like an IRA or 401(k). Talk to a financial advisor with expertise in retirement planning to learn how to leverage this option.

📈 Why are short-term CD rates so high right now?

Historically, CD rates are higher the longer the term, rewarding investors for committing their money for an extended period of time. However, in today's market, that isn’t holding true. Right now, some shorter-term CDs are offering more competitive rates than longer-term CDs.

That’s because CD rates closely follow the federal funds rate, which is currently elevated due to the Federal Reserve's aggressive interest rate hikes over the past year. The Fed raised the fed funds rate 11 times between March 2022 and July 2023, bringing it to a target range of 5.25% to 5.5%. But when the Fed cuts rates at one of its meetings later in the year, rates on CDs are bound to fall too.

  • Your money is safe. Your initial deposit and all interest earned are insured for up to $250,000 per depositor, per institution, by the FDIC or NCUA, making them a safe investment option.

  • Predictable returns. CDs provide a fixed interest rate for a set term, allowing you to predict what you’ll earn over the life of your term without risk.

  • Range of terms. You can find terms of three months to five years or longer to fit your financial goals. Rates for six-month CDs can outpace the average bank account, and longer terms offer rates comparable to high-yield accounts.

  • Early withdrawal penalties. If you need to access your funds before the CD matures, you'll typically pay a steep penalty.

  • Opportunity cost. By locking your money into a CD for a set term, you may miss out on higher returns from other investments.

  • Inflation risk. If the interest rate on your CD is lower than the inflation rate over your CD’s term, the purchasing power of your savings will decrease over time.

You’ll find a range of CDs offered by banks, credit unions and other financial institutions, each with trade-offs that depend on your budget, financial goals and interest in managing your account beyond your initial principal.

A traditional or fixed-rate CD is a deposit account that provides a fixed interest rate for a specific term that can range from a few months to five years or more. Traditional CDs are the most common type of CD offered at banks, credit unions and other financial institutions.

With a traditional CD, you make a one-time deposit that earns a fixed APY compounded over the life of your term. After the CD term expires, your principal and interest earned are either returned to you or rolled into another CD, depending on your preferences.

If you need to access your funds before the CD matures, you'll face a penalty fee that’s equal to some period of interest earned, depending on the term length. At maturity, you can decide whether to cash out your earnings or roll your money into a new CD term.

Jumbo CDs are a type of CD that requires a high minimum deposit, typically $100,000 or more. In exchange for access to this larger deposit, banks are willing to pay higher interest rates than those for traditional CDs.

The high opening deposit could be a barrier for investors. And in today’s high-rate environment, you could find shorter traditional CDs offering competitive rates, so it’s worth shopping around.

An IRA CD is a type of investment that combines the features of an individual retirement account with those of a certificate of deposit. In this way, you can invest your retirement savings in a CD while enjoying the tax benefits and potential higher returns associated with a traditional or Roth IRA.

It’s worth keeping in mind that IRA CDs are subject to the same contribution limits as traditional and Roth IRAs — which for the 2024 tax year is an increased annual contribution limit of $7,000 for those under age 50 and $8,000 for those ages 50 and older.

A bump-up CD — also called a “raise your rate” CD — builds in the ability for you to request a one-time rate increase if CD rates go up during your lock-in term. Longer term CDs may allow for more than one bump up. For example, Ally Bank allows you to request a bump up twice over a four-year term.

Not all banks or financial institutions offer bump-up CDs, but if they do, they’re likely to offer lower starting rates than those for a traditional CD in exchange for the chance to take advantage of a higher rate down the road without penalty or opening a new CD.

A no-penalty CD — also called a liquid CD or a breakable CD — allows you to withdraw your money before your CD’s maturity date without incurring an early withdrawal penalty.

These CDs often offer limited term options and lower interest rates when compared to traditional CDs in exchange for the flexibility to break your CD early. Some no-penalty CDs may also restrict how soon you can withdraw your money after opening the account or how many withdrawals you can make, and many require you to take out your full balance.

With rates at historic highs, the best high-yield savings accounts may offer comparable or even higher rates than a no-penalty CD with the same flexibility.

A variable-rate CD — also called a flex CD — is a type of certificate of deposit with an interest rate that can fluctuate periodically over the term of the CD based on market conditions. The interest rate on a variable-rate CD is typically influenced by an index or benchmark, such as the prime rate or the U.S. Treasury bill rate.

Unlike a fixed-rate CD, variable-rate CDs offer flexibility in a rising interest rate environment, as you're not locked into a fixed rate for the entire term. If interest rates rise during the term of your CD, your CD rate is likely to increase as well, helping you to take advantage of those higher rates. Yet if interest rates fall during the term of your CD, you could earn less than you would have with a fixed-rate CD.

Because variable-rate CDs are more complex than traditional fixed-rate CDs, it can be harder to compare options. And they’re typically best to consider when interest rates are low.

A brokered certificate of deposit is a CD issued by banks or credit unions but sold through a brokerage firm or financial advisor, rather than from the bank itself. Brokerage firms work with a network of banks and credit unions to offer a wide variety of CD types and terms. And these firms can often negotiate higher interest rates due to the volume of CDs they sell.

Brokered CDs make it easier to diversify your CD holdings across multiple banks and maturity dates, which can help you manage risk and optimize returns. Some brokered CDs can be sold on the secondary market before maturity, providing potential liquidity for investors who may need to access their funds early, though you could incur losses.

While brokered CDs themselves typically don't have fees, brokerage firms may charge a fee for their services, which can eat into your returns. These CDs also often require higher minimum deposits compared to CDs offered directly by banks, which may be a barrier for some investors.

Dig deeper: What is a CD ladder? How to build one — and capture high rates before they drop

How much you should invest in a CD is a personal decision. But before opening one, make sure you have sufficient liquid assets available to comfortably cover emergencies or unexpected expenses. A good rule of thumb is to keep three to six months' worth of living expenses in an emergency fund before investing in a CD.

Also factor in early withdrawal penalties when making your decision. If you think you might need to access your funds before the CD matures, you may want to invest a smaller amount, choose a shorter term or consider a no-penalty CD or HYSA. These considerations are especially important if you’re considering a jumbo CD, as the downside risk is higher.

Dig deeper: When is it worth it to break a CD? A finance expert's take on early withdrawals and breaking even

Whether you choose a brick-and-mortar bank or digital provider, here are the general steps to opening a CD.

  1. Compare your CD options. Shop around and weigh the best CD rates, minimum deposit requirements and terms available to determine how you want to invest your money. Consider the type of CD you want, such as a traditional CD, bump-up CD or a no-penalty CD.

  2. Complete the application. Digital providers’ CDs allow for a fully online application, while others might allow applying in person or by phone. You’ll typically provide your name, Social Security number, government-issued ID and proof of address.

  3. Fund your CD. Decide how much money you want to invest in the CD and transfer that amount from an existing checking or savings account.

  4. Keep track of your CD’s maturity date. Note when your CD term expires, as this is when you’re able to withdraw your funds without penalty. Most institutions will send you a reminder when your CD’s maturity date approaches.

  5. Decide what to do at maturity. When your CD matures, you typically have a grace period to decide whether to withdraw your funds, renew the CD for another term or transfer the money to another investment.

After a CD matures, you’re offered options for managing your funds that depend on the CD and bank. Most financial institutions offer a grace period of seven to 10 days within which you can decide what to do with your CD funds without incurring any penalties.

Here are four common options at CD maturity:

  1. Withdraw your funds. You can cash out your principal and earned interest within the grace period without penalty. Contact your bank or credit union and provide instructions on how you’d like to receive your money.

  2. Renew the CD. Many institutions offer automatic renewal, which rolls your principal and interest earned into a new CD of the same term. However, your rate could be lower than the original CD’s, so read the fine print.

  3. Choose a different CD. You can use your funds to open a new CD with a different term. A new CD can help you take advantage of higher interest rates on longer-term CDs or a shorter term if you know you’ll need access to your money sooner.

  4. Transfer your money to an HYSA. To maintain liquidity while earning a competitive interest rate, you can transfer your CD funds into a high-yield savings account, money market account or other savings account.

Every CD has a breakeven point, and it could be worth it to break a CD and pay the early withdrawal penalty in a few situations that include:

  1. Higher rates are available. If new CDs offer much higher rates than your existing CD, the difference in interest you stand to earn might outweigh any early withdrawal penalty. Do the math to see if reinvesting in a new one makes sense, especially if there’s a long time until maturity with your current one.

  2. You have unplanned expenses. If you face an unexpected financial emergency and don’t have sufficient funds available, breaking a CD may be a necessary last resort to avoid taking on high-interest debt, which could make your situation worse.

  3. You want to consolidate your high-interest debt. Using funds from a broken CD to consolidate high-interest debt or invest in a time-sensitive opportunity with a higher potential return than your CD might be a wise choice.

Kat Aoki is a seasoned finance writer who's written thousands of articles to empower people to better understand technology, fintech, banking, lending and investments. Her expertise has been featured on sites like Forbes Advisor, Lifewire and Finder, with bylines at top technology brands in the U.S. and Australia. Kat strives to empower consumers and business owners to make informed decisions and choose the right financial products for their needs.

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