Certificate of Deposit (CD) Definition & How CDs Work

What Is a Certificate of Deposit (CD)?

A certificate of deposit (CD) is a product offered by banks and credit unions that provides an interest rate premium in exchange for the customer agreeing to leave a lump-sum deposit untouched for a predetermined period of time. Almost all consumer financial institutions offer them, although it’s up to each bank which CD terms it wants to offer, how much higher the rate will be compared to the bank’s savings and money market products, and what penalties it applies for early withdrawal.

Shopping around is crucial to finding the best CD rates because different financial institutions offer a surprisingly wide range. Your brick-and-mortar bank might pay a pittance on even long-term CDs, for example, while an online bank or local credit union might pay three to five times the national average. Meanwhile, some of the best rates come from special promotions, occasionally with unusual durations such as 13 or 21 months, rather than the more common terms based on three, six, or 18 months or full-year increments.

How Does a CD Work?

Opening a CD is very similar to opening any standard bank deposit account. The difference is what you’re agreeing to when you sign on the dotted line (even if that signature is now digital). After you’ve shopped around and identified which CD(s) you’ll open, completing the process will lock you into four things.

1. The interest rate: Locked rates are a positive in that they provide a clear and predictable return on your deposit over a specific time period. The bank cannot later change the rate and therefore reduce your earnings. On the flip side, a fixed return may hurt you if rates later rise substantially and you’ve lost your opportunity to take advantage of higher-paying CDs.
2. The term: This is the length of time you agree to leave your funds deposited to avoid any penalty (e.g., 6-month CD, 1-year CD, 18-month CD, etc.) The term ends on the “maturity date,” when your CD has fully matured and you can withdraw your funds penalty-free.
3. The principal: With the exception of some specialty CDs, this is the amount you agree to deposit when you open the CD.
4. The institution: The bank or credit union where you open your CD will determine aspects of the agreement, such as early withdrawal penalties (EWPs) and whether your CD will be automatically reinvested if you don’t provide other instructions at the time of maturity.

Once your CD is established and funded, the bank or credit union will administer it like most other deposit accounts, with either monthly or quarterly statement periods, paper or electronic statements, and usually monthly or quarterly interest payments deposited to your CD balance, where the interest will compound. 

Why Would I Open a CD?

Unlike most other investments, certificates of deposit offer fixed, safe—and generally federally insured—interest rates that can often be higher than the rates paid by many bank accounts. And CD rates are generally higher if you’re willing to sock your money away for longer periods.

CDs have become a more attractive option for savers who want to earn more than most savings, checking, or money market accounts pay, but without taking on the risk or volatility of the market.

CDs vs. a Savings or Money Market Account

Certificates of deposit are a special type of savings instrument. Like a savings or money market account, they provide a way to put money away for a specific savings goal—such as the down payment on a house, a new vehicle, or a big trip—or to park funds that you simply don’t need for day-to-day expenses, all while earning a certain return on your balance.

But whereas savings and money market accounts allow you to vary your balance by making additional deposits, as well as up to six withdrawals per month, CDs require one initial deposit that stays in the account until it reaches its maturity date, whether that’s six months or five years later. 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?

Anyone who’s been following interest rates or business news in general knows that the Federal Reserve Board’s rate-setting actions loom large in terms of what savers can earn on their 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 Fed’s Federal Open Market Committee (FOMC) decides whether to raise, lower, or leave alone the federal funds rate. This rate represents the interest that banks pay to borrow money through the Fed. When Fed money is cheap (i.e., the federal funds rate is low), banks have less incentive to court deposits from consumers. But when the federal funds rate is moderate or high, banks can do better by paying consumers a competitive rate for their deposits.

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. Even worse for savers was that it left rates anchored there for a full seven years. During that time, deposit rates of all kinds—savings, money market, and CDs—tanked.

Beginning in December 2015, however, the Fed began to gradually increase the federal funds rate in light of metrics showing growth and strength in the U.S. economy. As a result, the interest banks were paying on deposits were rising, with the top CD rates an attractive option for certain cash investments. The federal funds rate began to fall in the later half of 2019, then were dropped to between 0% and .25% in March of 2020 in an emergency measure aimed at stifling the economic impact of the 2020 economic crisis. These lower rates currently make CDs a less attractive option for cash investors.

Beyond the Fed’s action, however, the situation of each financial institution is an additional determinant of how much interest it is willing to pay on specific CDs. For instance, if a bank’s lending business is booming and an increasing amount in deposits is needed to fund those loans, the bank may be more aggressive in trying to attract deposit customers. By contrast, an exceptionally large bank with more than sufficient deposit reserves may be less interested in growing its CD portfolio and therefore offer paltry certificate rates.

Are CDs Safe?

Certificates of deposit are one of the safest savings or investment instruments available, for two reasons. First, their rate is fixed and guaranteed, so there is no risk that your CD’s return will be reduced or even fluctuate. What you signed up for is what you’ll get—it’s in your deposit agreement with the bank or credit union. 

CD investments are also protected by the same federal insurance that covers all deposit products. The FDIC provides insurance for banks and the NCUA provides insurance for credit unions. When you open a CD with an FDIC- or NCUA-insured institution, up to $250,000 of your funds on deposit with that institution are protected by the U.S. government if that institution were to fail. Bank failures are exceptionally rare these days. But it’s good to know that a bank failure wouldn’t put your funds in jeopardy.

The key to ensuring your funds are as safe as possible is to make sure you choose an institution that carries FDIC or NCUA insurance (the vast majority do, but a small minority carry private insurance instead), and to avoid exceeding $250,000 in deposits in your name at any one institution. If you are holding more than that amount in deposits, you can maximize your coverage by spreading your funds across multiple institutions and/or more than one name (e.g., your spouse).

When Is Opening a CD a Good Idea?

Certificates of deposit are useful in a few different situations. Perhaps you have cash you don’t need now, but will want within the next few years—maybe for a special vacation or to buy a new home, car, or boat. For near-term uses like that, the stock market generally isn’t considered a suitable investment, as you could lose money over that period of time. 

Or maybe you simply want some portion of your savings invested very conservatively, or shun the risk and volatility of the stock and bond markets altogether. Though CDs don’t offer the growth potential of equity or debt investments, they also don’t carry a risk of downturns. For money that you want to absolutely ensure will grow in value, even if modestly, certificates of deposit can fit the bill.

One of the downsides of CDs can also be a useful feature for some savers. For those who worry they won’t have the discipline to avoid tapping into their savings, the fixed term of a CD—and the associated penalty for early withdrawal—provide a deterrent to spending that regular savings and money market accounts do not.

One version of this is using CDs for your emergency fund. This allows you to ensure you always have sufficient reserves on hand in case of an emergency because the amount in the CD will never decrease. And though you may incur a penalty if you have to dip into your funds early, the idea is that you would only do this in a true emergency, not for lesser but tempting reasons. All the while, you’ll be earning a better return while the funds are invested than if you had deposited them in a savings or money market account.

Where Can I Get a CD?

Virtually every bank and credit union offers at least one certificate of deposit, and most have a wide array of terms on offer. So not only is your local brick-and-mortar bank an outlet, but so is every bank or credit union in your community, as well as every bank that accepts customers nationwide via the internet. 

In addition, you can open CDs through your brokerage account. We’ll explain more on these later, but in short, these are bank certificates as well. Your brokerage firm simply serves as a middleman.

Why It’s Important to Shop Around

Before the internet, your CD choices were essentially limited to what you could find in your community. But with the explosion of online rate shopping, plus the proliferation of internet banks—and traditional banks opening online portals—the number of CDs one can consider is astounding. It’s now possible to shop for CDs from about 150 banks that accept customers nationwide and allow for opening an account online or through the mail. In addition to that, you’ll have access to a number of regional and state banks, as well as credit unions, that will do business with you based on your residency in their state.

As we’ve mentioned, though, the range of CD rates across these different institutions can vary widely. It’s a mistake to just open a CD at the bank where you already have a checking relationship without investigating how its rates compare with those you can earn elsewhere.

Fortunately, our weekly rate research will put the very best nationally available rates in front of you for every term, making it easy to maximize your earnings. You should still shop for options within your state or community, but with our lists of the top nationally available rates, you’ll be able to easily determine which rates are worth your consideration and which are not.

How Much Do I Need to Open a CD?

Each bank and credit union establishes a minimum deposit required to open each CD on its menu. Sometimes a bank will set a minimum deposit policy across all CD terms it offers, while some will instead offer rate tiers, providing a higher APY to those who meet higher minimum deposits.

In theory, having more funds available to deposit will earn you a higher return. But in practice, this doesn’t always hold true. For instance, having $25,000 ready for deposit will occasionally enable you to open a CD that is not available to others with lesser amounts. But many of the Top 10 rates in each CD term can be achieved with modest investments of just $500 or $1,000. And the vast 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?

There are two important considerations when deciding how long a CD term is right for you. The first centers on 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 maximum CD term length. In contrast, if you’re just socking away cash for which you don’t have a specific purpose in mind, you may opt for a longer term so as to maximize your interest rate.

Secondly, you’ll want to consider what’s expected to happen with the Fed’s rate. If it’s anticipated that the Fed will raise rates—and therefore bank and credit union CD rates will likely rise—short- and mid-term CDs will make more sense than long-term CDs, since you won’t want to be committed to a lesser rate for five years when new, higher rates appear. Conversely, an expectation that rates will decrease in the near term may trigger you to want long-term CDs, so you can lock in today’s higher rates for years to come.

What Is a CD Ladder and Why Should I Build One?

Smart CD investors have a specific tactic for hedging against rate changes over time and maximizing their return. It’s called a CD ladder and it enables you to access the higher rates offered by 5-year CD terms, but with the twist that a portion of your money becomes available every year, rather than every 5 years. Here’s how to do it.

At the outset, you take the amount of money you want to invest in CDs and divide it by five. 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, keeping your money a bit more accessible than if all of it were locked up for a full five years.

Why You Should Be Open to Odd-Term CDs

Whether you’re building a CD ladder or are saving towards a specific goal with a known timeline, stay open-minded to the very best CD deals you find rather than getting hung up on a specific term. The reason this is important is that, when some banks and credit unions offer a promotional CD to attract new customers, they may stipulate an unconventional term.

For instance, some of the best CD rates you’ll see have unlikely terms like 5 months, 17 months, or 21 months. It may be to stand out or, perhaps, to match the birthday the bank is celebrating or any number of other reasons. But if you can be flexible in considering these odd-term certificates instead of the conventional term you were planning, you can sometimes find yourself with a better-paying opportunity.

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, it will accumulate and be reported to you in the new year as interest earned, so that you can report it as income when you file your tax return.

Sometimes people get confused about this because they are not able to actually withdraw and use those interest earnings. So their expectation is that they will be taxed on the earnings when they withdraw the CD funds at maturity (or sooner if they cash out early). This is incorrect. For tax-reporting purposes, your CD earnings are taxed at the time the bank applies them to your account, regardless of when you withdraw your CD funds.

What Happens to My CD at Maturity?

In the month or two leading up to your CD’s maturity date, the bank or credit union will notify you of the impending end date. Its communication will also include instructions on how to tell them what to do with the maturing funds. Typically, they will offer you three options.

1. Roll over the CD into a new CD at that bank. Generally it would be into a CD that most closely matches the term of your maturing CD. For example, if you have a 15-month certificate concluding, they would likely roll your balance into a new 1-year CD.
2. Transfer the funds into another account at that bank. Options include a savings, checking, or money market account.
3. Withdraw the proceeds. They can be transferred to an external bank account or mailed to you in a paper check.

In any case, the communication to you will stipulate a deadline for you to provide instructions, with an indication of what the institution will do in lieu of receiving your guidance. In many cases, its default move will be to roll your proceeds into a new certificate.

Should I Let My CD Roll Over?

As a general rule, letting your CD roll over into a similar CD term at the same institution is almost always unwise. If you still don’t need the cash, and are interested in starting a new CD, rolling it over is certainly the path of least resistance. But it’s also virtually never the path of maximum return.

As we’ve mentioned, shopping around is imperative if you want to earn the top rate on your CD investments. And the odds are low that the bank where your CD is maturing is currently a top-rate provider among the hundreds of banks and credit unions from which you can choose a CD. It’s not impossible you’ll do well with a rolled-over CD, but the probabilities are against you, and shopping around is always your better bet.

Even if you find your existing bank is indeed a top contender, you’ll be able to move into that CD purposefully and with confidence that you’ve done your homework to score the best possible return.

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 don’t have options if your plans need to change. Whether you encounter an emergency or a change in your financial situation—or simply feel 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 you can know before you agree to the CD if the early withdrawal penalty 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 3 years, and a full year’s worth of interest for its long-term CDs. These are just examples—every bank and credit union sets its own early withdrawal penalty, so it’s important to compare EWP policies whenever you are deciding between two similar CDs.

It’s especially wise to watch out for early withdrawal policies 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’d 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 you haven’t kept very long, you could find yourself collecting less in proceeds than you invested. As a result, these types of EWPs are best avoided.

Specialty CDs: Bump-Up, Add-On, No-Penalty, Jumbo, and IRA

The most common CD type follows the standard formula of depositing your funds, letting them sit untouched until the end of the term, and withdrawing them upon maturity. But banks and credit unions also offer a variety of specialty certificates with different structures and rules.

Bump-up CDs

These are sometimes called raise-your-rate certificates. Bump-up CDs offer savers a chance to access a higher rate usually one time during their term. So if you open a 5-year certificate and rates rise during that period, you’ll have one opportunity to lock in at a higher rate currently offered by the bank, which will then apply for the duration of your term. Occasionally, bump-up CDs will allow two rate increases, although only for long-term CDs.

Add-on CDs,

Add-on CDs let you play around with your deposit amount, instead of your interest rate. Here you can open the CD with one amount, but make additional deposits to increase your invested principal. Some banks will allow as many add-ons as you like; others will stipulate a certain number of allowable add-ons per time period (e.g., per month or quarter), and a few will limit the add-ons to just one or two during the full term. 

No-penalty CDs

These sound enticing, as they seem to provide the interest rate benefit of a certificate of deposit, but with less risk should you need to cash out early. No-penalty CDs can indeed bridge the gap between a fully accessible savings account and a CD with an early withdrawal penalty. But as you can guess, « no penalty » comes with a price tag: a lower interest rate than you would be able to earn with a traditional CD. So it’s important to compare the rates of no-penalty CDs with what you can earn from a top savings or money market account.

Jumbo CDs

These are another product you may encounter when shopping for certificates. Jumbos are simply CDs with a large minimum deposit. No governing body prescribes the floor for calling a CD a “jumbo,” so each bank decides for itself. The most typical threshold is a $50,000 minimum deposit. Some institutions call $25,000 CDs a jumbo (or perhaps “mini jumbo”) certificate, while others reserve the jumbo label for CDs of at least $100,000.

IRA CDs

Certificates of deposit can also be a useful savings vehicle for retirement funds. Many banks and credit unions offer IRA CDs. Some have a separate menu of CDs that are available as IRAs, while other institutions allow any of their standard CDs to be set up as IRA CDs. One difference in either case is that IRA CDs must be held in an officially designated IRA account.

Getting a CD: Direct vs. Brokered CDs

If you have a brokerage account, you may have noticed CDs on offer there and wondered how they differ from certificates of deposit opened directly with a bank or credit union.

The first point is that brokered CDs are bank CDs, with the brokerage firm serving as a process-simplifying middleman. That said, there are some important differences.

Lower rates

Although brokered CDs occasionally offer rates competitive with direct bank certificates, more typically the rates on brokered CDs are lower. If maximizing your CD returns is a priority, you’ll generally be better off going straight to the source.

But what brokered CDs give up in rates they counter with convenience, especially for those holding multiple CDs. That’s because brokered CDs will be included on the same regular monthly or quarterly statements you already get for your brokerage account, with all maturity dates and terms shown. This makes tracking what you hold, and when each will mature, much simpler.

More convenience…

Opening a brokered CD is also a bit easier. As you already have an account with the brokerage firm, it will acquire the CD on your behalf. This spares you the bank paperwork of directly opening a CD and the extra statements you get afterward. Termination is also simplified: When the CD matures, the funds will typically move into your cash account at the brokerage firm.

…Except if you need to withdraw early

Early withdrawals are treated much differently for brokered CDs than direct bank certificates. If you need to cash out a brokered CD early, you are required to sell it on the secondary market. Although access to this marketplace is provided by your brokerage firm and is generally simple to navigate, there are no guarantees on what price you’ll be able to secure for your certificate. Key factors include whether you’re selling during a rising or decreasing interest-rate environment and the time left on your certificate. 

Selling on the secondary market is not necessarily a negative—it doesn’t always lead to subpar returns. But what you give up is any guarantee or predictability on how much of your proceeds you’ll retain.

Specialty CDs from Your Broker

Besides the standard brokered CD, there are two kinds of specialty CDs that are generally found only through brokerage firms:

Callable CDs

A callable certificate is a specialized CD, on which the issuing bank retains the right to recall the CD at any time. So while you hope to be locked into a certain interest rate for a certain number of years, at any point the bank can decide to end that arrangement and return your funds to you. While this won’t result in any penalties or losses for you, it can cause you to lose the opportunity of a favorable rate that was locked in for the future. For this privilege, the bank generally pays a somewhat higher interest rate. If this is a risk you want to avoid, then search your brokerage firm’s listing for “non-callable CDs”.

Zero-coupon CDs

Another specialty CD you might find at your brokerage firm is a zero coupon certificate. These CDs carry a face value, much like a savings bond does, and are sold for some lower initial price. The most important thing to know about zero coupon CDs is that you will be taxed on the earned interest every year, even though you will not realize the certificate’s gain until it matures. So careful tax planning is recommended.

Frequently Asked Questions

How does a certificate of deposit work?

A certificate of deposit is a simple and popular savings vehicle offered by banks and credit unions. When a depositor purchases a certificate of deposit, they agree to leave a certain amount of money on deposit at the bank for a certain period of time, such as 1 year. In exchange, the bank agrees to pay them a pre-determined interest rate, and guarantees the repayment of their principal at the end of the term. For instance, investing $1,000 in a 1-year 5% certificate would mean receiving $50 in interest over the course of one year, plus the $1,000 you initially invested.

Can you lose money on a certificate of deposit?

Practically speaking, it is almost impossible to lose money on a certificate of deposit, for two reasons. First, they are guaranteed by the bank or credit union that offers them, meaning they are legally required to pay you exactly the amount of interest and principal agreed upon. Secondly, they are generally also insured by the federal government, meaning that even if the bank or credit union went bankrupt, your principal would very likely still be repaid. For these reasons, certificates of deposit are considered one of the safest investments available.

What are the advantages and disadvantages of a certificate of deposit?

Some savers like certificates of deposit because of the safety they provide, as well the fact that they are perfectly predictable. On the other hand, certificates of deposit generally promise a very modest rate of return, particularly in recent years when the federal funds rate is at historically low levels. If the interest rate offered is below the current inflation rate, then investors in certificates of deposit will actually lose money on their investment, when measured on an inflation-adjusted basis. For this reason, yield-conscious investors might prefer investments that are riskier but offer higher potential returns.