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How do CDs work? Your complete guide to understanding certificates of deposit.
If you’re like many Americans, you likely sock money away in your savings account. But did you know that the average savings account interest rate is just 0.45%? If you want to save for a future goal and potentially earn much better returns, consider a certificate of deposit (CD).
A CD is a low-risk type of deposit account that helps you earn compound interest while locking in a higher yield for a set period of time. With a CD, you deposit your money in the account and commit to leaving it there for a few months to several years, depending on the CD's term. Essentially, you trade the liquidity of your funds to earn a higher annual percentage yield (APY).
Before choosing a CD, it’s important to learn how they work and the pros and cons involved. Doing so will help you choose the account that’s best for you and your financial goals.
What is a CD, and how does it work?
You open a CD by depositing a lump sum with a bank or credit union. (Note: At credit unions, CDs are known as share certificates.) The funds you deposit earn a fixed interest rate until the CD matures.
The appeal of a CD is it typically provides a higher interest rate than a traditional savings account. A CD pays a higher interest rate because you commit to leaving your money in the account for a specific period. For example, you may invest your money for six, 12, or 60 months.
While your money is in the account, the bank or credit union pays you interest, and that interest compounds — you earn interest on the money you deposit plus the interest your money earns. When the CD reaches its end date, you receive the original amount you invested plus the interest that accrued.
Depending on the terms of your account, the bank or credit union may deposit the interest you earn back into your CD or pay those earnings out to you at regular intervals (e.g., once a month or once a year). Yet unlike standard savings accounts, you must typically agree not to withdraw any funds from your CD until it reaches maturity. At that point, you can withdraw the funds or roll them into a new CD.
It's important to keep in mind that if you try to withdraw your cash before a CD reaches maturity, you could face an early withdrawal penalty. These penalties can cut into or wipe out the interest you earn on your balance, so it’s important to plan ahead and only deposit as much money into CDs as you feel comfortable leaving untouched for a predetermined period.
Additionally, CD rates can vary widely by financial institution. Currently, the national average CD rate for a 1-year term is 1.81%. However, some of the best CD rates are over 4%. Therefore, it’s essential to shop around for the best CD rates to maximize the earning potential on your savings.
Read more: How to calculate interest on a CD
Pros and cons of CDs
Like any other type of bank account, CDs have their pros and cons. They aren’t right for everyone, but they can certainly be a smart move at the right time for others. Below is a quick summary of those benefits and drawbacks, but you can also learn more about the pros and cons of CDs in depth.
Pros
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Unlike savings accounts, which have variable interest rates, CDs offer guaranteed returns. This makes them a low-risk way to grow your savings.
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CDs offer higher returns on average compared with other deposit accounts.
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When you open CDs from federally insured banks or credit unions, your deposits are insured for up to $250,000 (per depositor, per financial institution).
Cons
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If you need to access your cash before a CD’s maturity date, you’ll typically have to pay an early withdrawal penalty to do so.
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Although CDs are a safer savings option, they feature lower historical returns compared with higher-risk investments (by comparison) like mutual funds and stocks.
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The interest rates on CDs — especially long-term CDs — might struggle to keep up with rising inflation over time.
Types of CDs
The most common type of CD pays a fixed interest rate for a certain time. But there are other types of CDs that allow for more flexibility.
For example, no-penalty CDs allow you to make early withdrawals without paying penalties, but they usually have lower interest rates than other CDs.
If you're worried about losing out on higher rates while your money is locked into a CD, you may want to consider a bump-up CD. With this type of CD, you can request a rate increase if interest rates rise at your financial institution before your CD matures. In general, you can only request one rate increase per term with a bump-up CD, but some banks may allow for multiple requests for long-term CDs. The initial APYs on bump-up CDs are often lower compared to other types of CDs as well.
There are several types of CDs available, all with their own advantages and drawbacks. Learn more about the different types of CDs and which one may be the best fit for you.
CD saving strategies
Whether you’re saving for a down payment, home improvements, or another short- to mid-term financial goal, when you invest in a CD you might reach your objective faster. Yet because CDs lock away your money for a period of time, using them requires more planning than storing your cash in more liquid savings accounts.
Below are three common CD savings strategies to consider.
CD ladder
CD laddering is a savings strategy that involves opening multiple CDs with staggered maturity dates. By spacing out the dates at which your CDs mature, the goal is to maintain access to a portion of your savings at periodic intervals while still earning higher interest rates than you would in a more liquid type of deposit account.
Here’s an example of a CD ladder. Imagine you open three certificates of deposit — a 6-month CD, a 12-month CD, and an 18-month CD — and you split your savings into even amounts among each account. This setup would allow you to access or roll over the cash in your CDs at six-month intervals.
When the first CD in your ladder matures, you could open a new 2-year CD with that chunk of your savings (assuming you don’t need to use the money for another purpose). Opening a new CD would continue the cycle — permitting you access to a portion of your savings every six months while also enjoying the higher interest rates that CDs have to offer.
CD barbell
A CD barbell is another financial tactic that involves dividing your savings between multiple CDs with different maturity dates. However, with this approach, you choose long-term and short-term accounts with no medium-term CD options.
The idea of the barbell strategy is to maintain access to a portion of your cash savings by investing some of your funds in short-term CDs. With the remainder of your savings, however, the goal is to earn the highest interest rates possible (which may be available with long-term CDs).
Yet there are two potential flaws with this savings strategy. First, long-term CDs don’t always offer the highest APYs available. And if you lock in a rate on a long-term CD in an environment where rates are on the rise (as they have been in recent months), you might miss out on the opportunity to earn higher APYs in the future.
CD bullet
The CD bullet approach can be worth considering if you’re saving toward a big financial goal. This savings method involves opening several CDs with similar maturity dates. The goal is to have the money from multiple certificates of deposit become available around the same time.
Here’s how the bullet CD strategy works. Imagine you’re saving money for a down payment on a house that you plan to purchase in five years. To start the savings process, you deposit a lump sum into a five-year CD. The following year, you have more cash available, so you decide to open a four-year CD, which will mature around the same time as the original account you opened.
You repeat the process each year with additional lump sum deposits into new CDs (e.g., a three-year CD, a two-year CD, a one-year CD, etc.). After your CDs mature, you apply all the funds toward your financial objective including, of course, any interest your cash earns along the way.
How to compare CDs
CD rates and terms vary by bank or credit union, so shopping around is wise. When comparing CDs, consider the following factors:
Rates
Banks and credit unions control their rates, so you’ll find that CD rates can vary widely between financial institutions. Institutions that are trying to attract deposits — which can be turned around as mortgages and auto loans — will offer higher rates than those who have plenty of cash on hand to lend. Your corner bank might offer 1% APY, while you may see deals online for several times that.
Terms
The time frame for a CD can be as short as a month or as long as 25 years. With most CDs, your money is locked up in the CD until its maturity date, so you cannot access your funds without paying penalties. Generally — though, not always — longer terms give you a higher APY because you sacrifice liquidity.
Penalties
With a traditional CD, you pay a penalty if you withdraw money before its maturity date. Generally, you forfeit some of the interest that accrued. Depending on the CD’s term length and how early you take out money, you could lose between three to 24 months' worth of interest. In some cases, the penalty can eat into your initial deposit.
Minimum deposit
CD minimum deposits vary by bank or credit union and typically range from $500 to $5,000.
Alternatives to CDs
Although a CD can be a good option to grow your money, it may not be the best choice for all your financial goals. To make your money work harder, consider the following alternative financial products:
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High-yield savings accounts (HYSAs): With a high-yield savings account, you can earn a higher APY than with a traditional savings account. High-yield savings accounts don’t have the restrictions on withdrawals that CDs do, so you can access your cash without penalties.
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Money market accounts: Money market accounts are a type of deposit account that offer flexible access to your funds similar to a checking account, coupled with a higher interest rate than what you might get with a traditional savings account.
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Series I Bonds: For those looking for safe investment options, I bonds issued by the US Department of the Treasury can be a smart alternative. Series I bonds pay a fixed rate of interest, plus a rate of interest that adjusts with inflation. While CD rates stay the same for the CD’s term, I bonds can increase as inflation rises, providing you with some protection.
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Index funds: If you’re looking for higher returns, investing in index funds may make more sense than investing in CDs. Although index fund prices can fluctuate, historically, they provide higher returns than CDs. For example, the S&P 500 — which tracks the performance of 500 of the country’s top companies — has an annualized 10-year return of 9.64%.
Read more:
Frequently asked questions about CDs
If you still have questions about CDs, check out these answers to commonly-asked questions:
What happens when a certificate of deposit matures?
When a CD reaches its maturity date, you can either withdraw your money or renew the CD. If you opt for a renewal, you deposit the money into another CD at the same bank with a new term and interest rate. Depending on the bank or credit union the CD is with, you may have a grace period to decide whether to renew it.
Learn more: What should you do once your CD matures?
Is my money protected in a CD?
Yes, like other deposit accounts, your CD bank account funds are typically federally insured, either through the FDIC or the NCUA. FDIC-insured and NCUA-insured funds are covered up to $250,000.
Is it better to put money into a CD or savings?
You may be weighing CDs vs. savings accounts. With some effort, you can find outstanding rates for both. But which account is best for you is dependent on your goals.
A savings account makes sense for the money you may need in the near future, such as in the next six to 18 months. Because there aren’t penalties for taking money out of your savings account, they’re a good fit for your emergency fund and other short-term savings goals.
A high-yield CD allows you to earn a higher interest rate than savings accounts but is less liquid, so they’re best for longer-term financial goals or a big purchase, such as putting a down payment on a house or buying a car. Only put money into a CD that you won’t need to cover routine or emergency expenses. Otherwise, you’ll have to pay withdrawal penalties.
Is it better to invest in CDs or stocks?
Whether it’s better to invest in CDs or stocks depends on your age, goals, and risk tolerance.
If you’re young with decades until your target retirement date, investing in the stock market is likely the best choice. You can take advantage of market increases and compounding, so your money will have more potential for growth. And because of your age, you have more time to recover from market fluctuations.
A CD is a safer investment than the stock market if you’re older — or if your goals have a shorter time horizon, such as one to five years. You’ll likely earn a lower return, but you don’t have the risk of losing your money like you would with stocks.
Not sure which is best for you? Meet with a financial advisor for personalized advice.
Can you add money to a CD?
In general, CDs only permit a fixed amount of cash. Once you’ve opened a CD, you cannot add money to the account (with the exception of add-on CDs).
However, you can use any additional funds to open another CD. You can open another CD with the same bank or shop around with other banks and credit unions to find the best rates.
