Complete Guide to Certificates of Deposit

Learn what CDs are and how they work

Certificates of deposit (CDs) are a safe way to earn interest on your savings. But there is a catch. Your money won’t be as accessible as with a regular savings account. The good news is they offer higher returns than you would get with a traditional savings account.

But how do CDs work? And when should you use them? Here’s everything you need to know about certificates of deposit.

What is a certificate of deposit (CD)?

Certificates of deposit, or CDs, are a type of federally insured savings account that have fixed interest rates and a set maturity date. CDs typically have better interest rates and they don’t have monthly fees.

How do certificates of deposit work?

When you open a CD account, you’re lending your money to a bank in exchange for a guaranteed interest. This is how banks build up the funds that they need to make loans and turn a profit.

The investor deposits money in an account where it must stay for an agreed period to earn the promised interest. Typically, the longer the period, the higher the interest. In general, CDs provide a higher rate of interest than you could get from a savings account. However, you must agree to lock in (i.e., not withdraw) the money you invest for a set period.

Each CD has an established maturity date or term length. When you purchase a CD, you can choose the term length, which best suits your financial needs — often six months, one year, or three years. Most CDs mature within five years, but you can find CDs with maturity periods spanning up to 20 years.

Many CDs come with a minimum deposit requirement, which can be $500-1000 or $10,000+ depending on the bank and type of CD.

Because the bank uses your locked-in deposit to make long-term investments, most CDs charge an early withdrawal penalty. This discourages you from using the funds before your CD matures.

What types of CD accounts are there?

With a traditional CD, you’ll have a fixed interest rate and withdrawal date. But other types of CDs come with adjustable rates and allow you to access your money before it matures. Here’s a brief overview of the various types of CD products available.

CD TypeFeaturesWhat to Consider
Traditional CDPays a fixed interest rate for a certain period.Early withdrawal penalty. Less flexibility.
Variable-Rate CDPays an interest based on the varying rate of an index fund.Since rate will vary, you may earn more or less than you expected
IRA CDEarns interest. Money is only taxed when it’s withdrawnEarly withdrawal penalty.
Fixed-Rate CDPays a set interest rate for the term’s lifetime.Liquid CDs, callable CDs, and traditional CDs are all examples of fixed-rate CDs.
Jumbo CDIntended for investments of $100,000 or more.Pays higher interest rates. The Federal Deposit Insurance Corporation only insures up to $250,000
Brokerage CDAvailable through a stockbroker or online brokerage.May charge a flat fee or a percentage of the investment amount. Some brokered CDs may not be FDIC-insured.
Bump-Up CDGives you the chance to “bump up” to the higher market interest rate in the event rates go up during the CD’s term.Only one rate increase is usually permitted.
Zero-Coupon CDAvailable at discounted prices.No interest is paid out until the CD has matured.
Uninsured CDNot insured by any institution including the FDICTypically pays a higher interest rate than traditional CDs-If the CD issuer goes bankrupt, you run the risk of losing your investment.
Thrift CDAvailable through thrift institutions like credit unions and savings-and-loan institutions.You may need to join this institution or hold another account with them to qualify.
Callable CDIt can be “called back” or closed by the bank at any time. It offers higher interest rates.Bank can close the CD before its term is up if interest rates go down. You cannot cancel the CD if interest rates go up and invest at a higher rate.
No Penalty CDNo early withdrawal fee.Pays a lower interest rate than a traditional CD.
Liquid CDPermits withdrawals at all times.Pays a lower interest rate than a non-liquid of the same term.
Add On CDAllows you to add money to your CD before its maturity -Additional amount earns the same interest rate as the amount used to purchase the CD initially.The majority of add-on CDs only allow additional deposits of a specified minimum amount.
Index-Linked CDAssociated with a specified index, -Return might be 100% of the index performance or another percentage, like 90%.If the linked index declines, there may be no profit. You will collect your principal back.
Bear CDPays an interest rate inverse to the agreed-upon market index -If the linked index declines, the CD collects interest.It is typically used as a hedge against declining stock prices.
Bull CDPays interest at a rate linked with a rising index.If the market goes into a bear phase and declines, you’ll receive a minimum rate that must be paid.

Certificate of deposit rates and why they matter

Your CD rate determines how much interest you’ll earn. In general, the longer your term, the higher the interest rate.

Here’s what you can expect:

Financial ProductNational Average Rate
Savings Account0.09
1-month CD0.10
3-month CD0.19
6-month CD0.33
1-year CD0.48
2-year CD0.62
3-year CD0.74
4-year CD0.81
5-year CD0.94

*Rates as of January 20, 2020 (source).

CD account rates are generally higher than a regular savings account. As such, you’re better off investing in a CD than a savings account, even if it’s just for a short period. Further, you’ll notice after doing a quick online comparison of banks that there are many offering interest rates well above the national average.

CD ladders

If you need more consistent access to your savings, but still want a CD’s stable interest earnings, consider building a CD ladder.

They are easy to set up. Open several certificates of deposit accounts at once and stagger their maturity dates by a period of six months to a year. For example, if you had $5,000 to invest, you would invest $1,000 in a one-year CD, another $1,000 in a 2-year CD, and so on. Then, as each account matures, you’d reinvest that money in a new five-year CD. If you keep this up over the next decade, you’ll end up with all of your savings in longer-term (five-year) CDs, with a new account reaching maturity every year.

Depending on your savings goals, you can choose to set up a CD ladder with terms that expire every few months. Or you may want to take advantage of longer-term payouts by opening one-year, three-year, and five-year CD accounts.

By building a CD ladder, you can safely stretch your savings over time and meet your financial goals faster.

Pros and cons of CDs

Although CDs are a fairly solid investment option, they have their strengths and weaknesses.

Advantages of CD accounts

CDs are a safe, low-risk option. If you purchase a CD from a federally-insured bank or credit union, your money is fully backed by the government (up to $250,000). Keep in mind that if you choose to purchase a CD account through a brokerage firm or independent salesperson, you’ll lose this protection.

Also, CDs offer higher returns than traditional savings accounts.

Plus, CDs are flexible, allowing investors to choose from many different term lengths. This lets you decide which option is best for your individual savings goals.

Disadvantages of CD accounts

When you invest in a CD, you lose access to your money for a set timespan. Even if you run into a financial emergency, it will be difficult to withdraw the funds you need. If you must take out your money, you’ll likely have to pay an early withdrawal penalty. You may have to forfeit your earned interest or reduce your principal.

Also, CDs don’t adjust to reflect the rate of inflation. Although you’ll gain consistent interest, your funds may not have as much purchasing power if inflation outpaces your interest rate.

And although CDs are more reliable than stocks and bonds, they lack the potential for higher returns. If you opt to invest in CDs, you’ll miss out on the increased returns of more high-risk, high-reward investment opportunities.

Alternatives to CDs

If you’re on the fence about investing in a certificate of deposit, you may benefit from one of these alternative investment options.

  • High interest savings accounts. A high-yield savings account may offer a comparable or higher interest rate, while also giving you consistent access to your funds.
  • Bond funds. Bonds usually have a higher interest yield than CDs because they come with more risk (though that risk level can change depending on the financial climate). Additionally, bond funds don’t usually have a withdrawal penalty, so you can use your money when you need to.
  • Paying down high-interest debt. If you have credit card debt or other balances with double-digit interest rates, paying it off first will give you a higher rate of return than a CD.
  • Dividend-paying stocks. You can earn a significantly higher rate of return by investing in a company that pays dividends. However, you’ll also be at the mercy of the market.

With more risk comes the potential for a higher reward, but you also put your principal on the line.

When do CD accounts make sense?

CDs are best for those who want to protect (and grow) their savings and can afford to stash their money away for months or years at a time.

If you know that you won’t need access to your money in the immediate future, you can safely store your funds for major purchases later down the road. Plus, if you struggle with impulse control, keeping your money in a CD is a great way to avoid dipping into your savings before you’re ready to make that big purchase. For example, you may benefit from a CD if you’re saving for a down payment on a mortgage, for retirement, or your child’s college education.

However, CDs aren’t just for long-term savings goals. You can strategically use short-term CD accounts to give your money an extra boost since CDs offer higher interest rates than traditional savings accounts. This can be an excellent first step for those who are brand new to the investment world and want a guaranteed return.

Overall, CD accounts are a safe investment opportunity for those who want to avoid the risks of the stock market.

How to choose a certificate of deposit

Here are some additional tips for making a final decision on selecting the CD that’s best for you.

Consider different CD types

In addition to the fixed rates of traditional CDs, some CDs provide adjustable rates, along with other potentially appealing features. For example, bump-up CDs allow for a one-time upgrade if market rates rise before your term ends.

Other types include indexed CDs and callable CDs.

Find out whether the CD is insured

Are you buying a CD from a brokerage firm or salesperson? If your CD is not government-insured by the FDIC, it’s imperative to ensure that you’re working with a reputable institution. Research your chosen firm thoroughly, and consider contacting your state’s consumer protection office. Be aware that brokers are not required to be licensed or certified, and they don’t have governmental oversight.

Avoid automatic rollovers

When your CD reaches maturity, you can opt to cash out or automatically roll over your funds into a new CD with the same terms. Before you choose, check with your bank and its competitors to see if you can land a better deal.

Frequently asked questions about CDs

How are CD earnings taxed?

Interest income is added to ordinary income and is taxed at rates according to the year’s income tax brackets.

So if you are a single filer who earned $100 in interest income from a CD in the 2019 tax year and your taxable income was $60,000, your earnings would be taxed by the federal government at a rate of 22%. That means you would owe $22 in taxes, giving you a $78 net yield after federal taxes.

Interest income is reported on Form 1099-INT.

States that charge income tax will also charge tax on interest income. Continuing from the above example, if you lived in California, you would need to pay an additional 9.3% in taxes on the CD earnings. This would subtract another $9.30, leaving your net earnings at $68.70.

What happens to my CD at maturity?

When your CD hits maturity, you will have the option to withdraw the principal you deposited initially–along with the interest you earned over the term. However, if you’d like, you can often reinvest your money into another CD to keep earning. Some institutions have options to auto-renew CDs. Although, it’s always good to shop around before agreeing to another term to ensure you are getting the best rate for the time and money you invest.

Are certificates of deposit FDIC-insured?

The Federal Deposit Insurance Corporation (FDIC) covers CDs and other time deposits up to $250,000 per person at insured banks. The insurance covers the principal and any accrued interest. You can find out if a bank is insured by calling the FDIC at 877-275-3342 or using its directory tool.

Do certificates of deposit compound interest?

CD accounts often do compound interest, however, the frequency at which they do so varies by account. It could be on a daily or monthly basis. By looking at the annual percentage yield (APY) of a CD, you can see the amount you can expect to earn in one year with compound interest factored in.

Are certificates of deposit tax-exempt?

Certificates of deposit are not exempt from taxes. You will be charged income taxes on the interest you earn as part of your ordinary income.

What does CD stand for?

CD comes from a “certificate of deposit.” In the past, the certificate was a paper document that showed proof that your funds were held in a bank at a certain rate. Today, CDs don’t come with a paper certificate. But more importantly, the money in a CD is still federally insured up to $250,000 per account at banks and credit unions.

What if I need to withdraw my money early?

If you withdraw your money from a CD early, institutions will typically charge a penalty that amounts to a portion of the interest you would have earned. For example, Ally’s early withdrawal penalties range from 60 to 150 days of interest. In most cases, the penalty you receive depends on the length of your CD term. Some banks do offer penalty-free CDs; however, they usually come with lower APYs.

How are CD rates determined?

The rates on a CD typically depend on the length of the term, the current interest rates in the market, and how much your bank predicts it can earn with your investment amount. The more you invest, and the longer your term, the higher your interest rate is likely to be. You can also watch the market trends to see if interest rates are expected to rise, fall, or stay the same.

Are CDs safe?

CDs are one of the lowest risk investment options available. They are insured by the FDIC and generally have higher interest rates than savings or checking accounts. Maximize your returns by choosing a reputable bank with competitive APYs and ensure you can keep your money in the account until it reaches maturity.

Are certificates of deposit worth it?

As with any financial investment, you need to do your due diligence before moving forward with purchasing a CD.

Begin by browsing the leading certificate of deposit rates to ensure you’re getting the best deal. Compare interest rates, term lengths, and penalties side-by-side to determine which offer is best for your financial situation. And once you’ve chosen a CD, thoroughly review the disclosure statement and ensure you understand all of the terms before moving forward.