How Do CDs Work? Facts You Need To Know
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Summary:
A certificate of deposit — or CD for short — is an excellent secure, low-interest investment vehicle. In exchange for an initial deposit, a CD will typically pay higher interest rates than most savings accounts and money market accounts. However, unlike these accounts, you can’t withdraw from a CD until it matures, making it a much less liquid investment than other options.
Savings accounts, money market accounts, and certificates of deposit all offer low-interest, secure investment options for your money. Among the three, a CD is a unique option that produces guaranteed returns at mostly higher interest rates in exchange for lower liquidity.
But how do CDs work? And how are they different from other investment vehicles, like money markets, savings accounts, or bonds? In this article, we’ll take a deep dive into what certificates of deposit are, how they work, and what alternatives may be better investment choices for your money.
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What is a certificate of deposit?
A certificate of deposit (CD) is a simple financial product offered by banks, credit unions, and even brokerage firms. Typically, CDs are offered at a flat rate and funds cannot be withdrawn for a certain period without an early withdrawal penalty. After the allotted time, the CD “matures” and the investor receives both the principal and interest amount.
If you’re interested in purchasing a CD, you must make an initial deposit into the account, usually in denominations of $1,000. However, depending on the type of CD you purchase, you may have to contribute a much larger or smaller sum. A jumbo CD, for instance, may require a down payment of $250,000.
IMPORTANT! If you try to withdraw your money from a CD before its maturity date, you’ll likely incur an early withdrawal penalty. These penalties will vary depending on the CD’s financial institution, but it’s often represented as a form of accrued interest. So instead of a $100 penalty, you would pay six months’ interest.
How long does a CD take to mature?
CDs mature at varying rates, as some have terms that only last six months while others may mature after five years. If you bought a one-year CD, that would mean that you have to leave your money in the account for one year. After a year passes, you would receive your initial principal along with the interest earned on the investment. If you buy a five-year CD, then you would be expected to wait five years to reach the maturity date.
In some cases, a financial institution can offer long-term CDs with maturity dates that are upwards of 10 years. Given the longer term, these products tend to have a higher interest rate, although that isn’t always the case.
Pro Tip
While it may be annoying to keep your money locked away for a certain period of time, you can use different maturity dates to your advantage through a CD ladder.
A CD ladder involves buying multiple CDs with different maturity dates, say a one-, two-, and three-year CD. Once the one-year CD matures, you use the funds to purchase another three-year CD and keep the ladder growing. This way you receive regular returns and can take advantage of better CD rates.
What is the interest rate on a CD?
Interest rates fluctuate depending on the CD’s initial cost and maturity date. For instance, a CD with a $1,000 price and a one-year maturity date may offer a 3.6% interest rate, but a CD that costs $1,500 with a two-year maturity date may offer as high as 3.9% depending on market conditions.
Because a financial institution has guaranteed access to funds for a specific amount of time, CD rates are typically higher than those for savings accounts and money markets. Using the comparison tool below, you can get a better idea of average interest rates and minimum deposits most CDs require.
How do certificates of deposit compare to other investments?
While CDs can be great investment products, you may find that an alternative option may be better for you.
CDs vs. savings accounts
On average, CD interest rates are much higher than the 0.10% to 0.20% average customers can often expect from a regular savings account. The obvious reason for this is that regular savings accounts allow customers to withdraw their money at will and without penalty. CDs generally do not allow withdrawals for a fixed period, and there are penalties if you withdraw money early.
That being said, you can also find high-yield savings accounts with interest rates between 1% and 3%. These accounts can be especially attractive if you prefer a more liquid investment but still want the high interest rates a CD can provide.
Finally, both your savings account and your CD are FDIC (Federal Deposit Insurance Corp.) insured for up to $250,000, making both extremely stable investments. If you didn’t like the above CD terms and interest rates, take a look at some of the high-yield savings accounts below.
CDs vs. money market accounts
CD rates tend to be higher than money market accounts, though you can still find money markets with rates between 1% and 3%. However, short-term, low-investment CD products may actually have lower interest rates than money market accounts offer.
The main advantage of a money market account is that most offer withdrawal options and therefore have variable balances. CDs do not typically offer withdrawal options without penalties, so it is often necessary to buy multiple CDs if you want to fill out your portfolio.
One important difference is that money market accounts have variable interest rates, whereas CDs have a fixed interest rate. A money market’s rates fluctuate based on stock market conditions and performance, whereas a CD has a fixed rate with a guaranteed return. This makes CDs safe investments compared to a money market account, although both are federally insured.
To get a better idea of what money market accounts offer compared to CDs, take a look at some of the accounts below.
Pro Tip
A healthy investment portfolio balances risk and reward. Every financial product will carry a different interest rate — or annual percentage yield (APY) — depending on applicable fees, and each will also provide varying degrees of liquidity. It’s important for any portfolio to be diversified to ensure market forces generate positive wealth trends.
Pros and cons of CDs
As with any investment vehicle, it’s best to compare the risks and benefits of a CD before purchasing one. You may find that the pros don’t actually outweigh the cons.
Types of CDs
If you decide that CDs are the best investment option for you, your next step is to determine what kind of CD to purchase. Take a look at the table below to get a better idea of which CD is the best investment for you.
| CD Type | Characteristics | Example |
|---|---|---|
| Traditional | Traditional CDs are the most common type. An investor deposits funds at the beginning, then the CD pays a fixed interest rate over a defined period, after which they can receive the principal or roll it into another CD. | You deposit $1,000 into a six-month CD paying 3% annually. Six months later, you receive your $1,000 plus interest earned. |
| Bump-up | A “bump-up” is a traditional CD that allows you to “bump up” to a higher interest rate if the institution holding the CD raises the rate of a similar term CD. Bumping up to a new rate is typically only allowed once per term. The rates on bump-up CDs are less than that of a similar-length traditional CD. | You buy a three-year $1,000 bump-up CD with an annual rate of 2%. Six months later, the bank raises the three-year rate to 2.75%. You can ask the bank to increase your rate for the next 30 months. |
| Step-up | Like a bump-up, the CD moves to a higher rate over time. However, step-up CDs automatically raise the rate by a predetermined amount at specified times during the term. | You purchase a three-year CD at 1.75%, where the rate goes up by 0.25% every year. |
| Liquid (no-penalty) | A liquid, or no-penalty CD, does not charge early withdrawal fees, allowing you to withdraw your money if needed. These CDs typically earn a lower rate than a traditional CD of the same term. | Compared to the traditional CD example above, a similar $1,000 two-year no-penalty CD will have a rate of less than 3%. |
| Zero-coupon | Similar to a zero-coupon bond, a zero-coupon CD does not pay periodic interest payments. Instead, an investor purchases the CD at a discount to its par value, and upon the end of the term, you will receive the par value. | You purchase a two-year zero-coupon CD with a par value of $1,000, for $985. Upon maturity in two years, you will receive $1,000, earning $15 in interest. |
| Callable | Similar to a traditional CD, this CD pays a fixed interest rate for a set period. However, the financial institution has an option to “call” or buy back the CD before the term ends. An institution would do this if the interest rates have fallen below the level they are paying this callable CD. | You buy a two-year CD paying 3% annually that is callable after one year. The prevailing interest rate drops during the first year so similar CDs pay 1.5%. The institution exercises its call provision, repurchasing your CD. You receive the original principal plus any interest earned. |
| Brokered | A brokered CD is sold through a brokerage firm. This means you don’t have to open an account at multiple banks to shop for the best rates. Instead, you can have one account hold CDs of different types, maturities, and financial institutions. A brokerage firm can also buy or sell CDs on the secondary market. | You open a brokerage account with a firm and buy a CD offered through the brokerage platform. The CDs can take the form of any CD on this list. |
| High-yield | As the name implies, these are typically traditional CDs with a relatively high yield. | You purchase a two-year high-yield CD that pays 3.5%, whereas other CDs are paying 2.75%. |
| Jumbo | Jumbo CDs require a large upfront deposit, typically $100,000 or more. An institution could reward an investor for a large deposit with a higher rate, though that may not be the case. | You buy a $250,000, two-year jumbo CD paying 2.5%. By comparison, a traditional non-jumbo two-year CD pays 2.4% and requires only $1,000. |
| Add-on | Most CDs require you to deposit all of the CD funds upfront and don’t allow further contributions. An add-on CD lets you add more money during the term, though there may be limits on the number of times you can “add on.” | You purchase a two-year add-on CD paying 2% for $1,000. Then, every six months, you deposit an additional $500. At the end of the term, you receive the deposited funds plus any interest earned. |
| Foreign currency | A foreign currency CD allows you to use U.S. dollars to initially purchase a CD. Those funds are then converted to a foreign currency (pound, euro, etc.) and then back to U.S. dollars at maturity. This CD introduces additional risks to your money, such as the risk of a dropping foreign exchange rate. | You buy a two-year euro-denominated CD paying 3% for $10,000. Your money is converted into euros at the current exchange rate and earns interest. Upon expiration, the principal and any interest are converted back to the U.S. dollar at the exchange rate at that time. |
Pro Tip
While most brokered CDs originate in traditional financial institutions, some of them are securities-based. While this may allow the broker to offer them at a better interest rate for the given CD terms, securities-based CDs tend to not be FDIC- or (for CDs issued by a credit union) NCUA-insured (National Credit Union Administration).
Online banking and CDs
Today, there are a vast and diverse number of online financial institutions and services available. Most people have an online savings account, and these services generally offer a higher APY because the institution pays less overhead to run the business.
With this in mind, it makes sense that CD rates from online institutions would be proportionally compared to those offered at brick-and-mortar institutions. It’s common for some large online institutions to offer multiple CDs with higher than average interest rates for a long-term CD, as well as a lower early withdrawal penalty.
The disadvantage of purchasing CDs with online institutions is a lessened degree of customer service and liquidity in exchange for more money upon maturity. Transaction times are generally slower with online institutions, and deposit accounts often have several days of lag time.
FAQs
Are CDs from banks different than credit unions?
Generally speaking, bank CDs and credit union CDs are very similar products. A credit union may offer more personalized service and a slightly better APY, whereas a bank may have a more robust portfolio of online services.
In addition, bank CDs are insured by the Federal Deposit Insurance Corporation, while credit union CDs are insured by the National Credit Union Administration. In the end, whether you choose a bank or credit union is largely a matter of personal preference.
Is a CD the same thing as a bank account?
No. Unlike a checking or savings account, funds cannot be withdrawn from a CD before its maturity date without a penalty.
Key Takeaways
- CDs are a secure financial product with slightly better rates than most traditional bank accounts and money markets.
- The return on a CD depends on the CD’s term, up-front cost, and annual percentage yield.
- Nearly all CDs are insured through the FDIC or NCUA.
- CDs have fixed interest rates, and online institutions may be able to offer you better rates than brick-and-mortar branches.
- There are several different kinds of CDs, so be sure to compare all your options before purchasing one.
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