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What is a CD (certificate of deposit)?

What is a CD (certificate of deposit)?
Catherine Hiles
Updated October 18, 2021
8 Min Read

A certificate of deposit, or CD, is a type of savings account that offers a higher interest rate than a traditional savings account. When you take out a CD, you agree to the term, or length, of the account and cannot access the money during that time without paying a penalty. CDs guarantee that you’ll keep the money in the account for the agreed-upon term, which gives banks added security, and that means higher interest rates for you.

How does a CD work?

When you open a CD, you must commit to keeping the money in the account, untouched, for an agreed-upon amount of time. Your bank or credit union will give you a fixed interest rate for that time period, which means you will know exactly what kind of return you’re getting on your investment. 

If you need to withdraw money from your CD before the term is up, your financial institution will likely charge you a fine in order to do so.

CD terms vary from a few months to several years. You’ll agree upon a term that works well for you when you open your account. In general, the longer the term, the higher interest rate you will be given. That’s because longer-term CDs are a better bet for financial institutions.

Once the term is up, you’ll either be able to withdraw the money from the CD or renew the CD for the same term as before.

How are CD rates determined?

The interest rate you get for your CD depends on your bank or credit union. If you shop around, you may find higher rates at institutions other than the ones at which you typically bank. 

In general, though, a CD rate is determined by the Federal Reserve Board. When the Fed sets interest rates low, there’s less incentive for banks to offer competitive CD rates. That’s because, when the Fed’s interest rate is low, it doesn’t cost a lot for banks or credit unions to borrow money, so there’s less incentive to offer high rates on savings accounts. But as the Federal interest rate goes up, so will CD rates, because the bank’s costs are higher.

All this means that it’s better for you, the saver, to open a CD when interest rates are high, because you’ll get a better return on investment.

CDs vs. savings accounts

A CD is a good option if you have a sum of money that you know you won’t need for a certain period of time. If you think you might need to withdraw from your savings at any point, though, a savings account or money market account is a better bet. 

That’s because most savings accounts allow you to withdraw money whenever you want (though there’s usually a monthly limit on how many withdrawals you can make). With a CD, you must leave your money untouched for the term of the agreement or risk paying an early withdrawal penalty.

Savings accounts also allow you to deposit money whenever you like, so you can contribute and build them over time. With a CD, once you deposit the lump sum you’re unable to contribute any more money. However, you can have a CD and a separate savings account if it makes sense so you can earn a higher interest rate on a lump sum and still save money and be able to withdraw funds from your regular savings account when needed.

When to open a CD

If you’re looking to protect a sum of money for a future purchase, such as a house down payment or a car, a CD can keep it safe until you need it. Since you’d have to pay a penalty to withdraw the money, you know it’ll still be there, untouched, when you need to use it.

You can also take advantage of CDs if you want to get a higher interest rate than on a traditional savings account but the thought of investing in stocks and bonds makes you nervous. While stocks and bonds can have a higher return on investment, they are also riskier. With a CD, you’re guaranteed to make a return at the same interest rate for the duration of the CD term.

Are CDs safe?

If you’re looking for a safe way to save money, CDs are about as safe as it gets. That’s because they guarantee a return on investment by the end of the term. When you first open a CD and agree upon the term and interest rate, your financial institution cannot lower or raise your interest rate for the duration of the term. So if you open the CD when interest rates are high and they dip during the CD term, you’re still guaranteed to get the higher rate you signed up for when you opened the account.

Additionally, the money you save in a CD is usually protected by the government. As long as your institution is insured by the FDIC (for banks) or the NCUA (for credit unions), your investment will be safe up to a certain threshold (usually $250,000) if that bank or credit union fails during the term of your CD.

Pros and cons of CDs

Like with any type of savings or investment account, CDs have a variety of pros and cons.

Pros

  • CDs have higher interest rates than regular savings accounts or money market accounts.
  • Your interest rate is guaranteed, even if the Fed decreases interest rates during the term of your CD.
  • Your money is federally insured as long as your institution is affiliated with the NCUA or FDIC.
  • When you deposit money in a CD, it’s safe there for several months or years and you’ll be less tempted to spend it.

Cons

  • Once you open a CD, you cannot access your money until the term is up.
  • CDs tend to earn less than stocks or bonds over time, even though they are safer.
  • If you do need to withdraw money before the CD term is up, you’ll be met with a hefty penalty.
  • The ROI of CDs is lower than investing in stocks and bonds.

What types of CDs are there?

If you’re thinking of opening a CD, it’s important to understand the different types so you know which one is right for you.

No penalty

While some CDs will charge you a penalty for withdrawing money before the CD term is up, a no-penalty CD will waive that fee. But in exchange, you’ll likely be offered a much lower interest rate for this type of CD. 

High yield

A high-yield CD has a higher interest rate than many other types of CDs. It’s more common to find these offered at online-only banks and credit unions than at brick-and-mortar institutions.

IRA

This type of CD holds your money in a retirement account that has accompanying tax advantages.

Jumbo

A jumbo CD is similar to a regular CD, but you usually need a much higher amount of money to open one. You might need to invest $100,000 or more, but in return you will get a much higher interest rate and therefore make more money in the long term.

Brokered

Rather than being offered by a bank or credit union, a brokered CD is offered by a third-party, such as a brokerage firm.

Bump up

With a bump-up CD, you have the option to request an increased interest rate one or two times during the CD’s term. In exchange for this, you’ll probably start off with a lower interest rate — but if the Fed raises its rates dramatically during the term of your CD you’ll have the opportunity to take advantage of that rate hike.

Step up

A step-up CD will automatically increase your interest rate at specified intervals during the term of your CD.

Frequently asked questions

Now you know the basics of a CD, but you may still have some unanswered questions. The following are the most frequently asked questions about this type of savings account, along with answers to help guide you in the right direction.

Where can I get a CD?

You can get a CD from most banks and credit unions in the U.S. It’s a good idea to check with your own institution first to see what they will offer, but it’s also smart to shop around and see where you can get the highest rate.

You may find that online banks will give you a higher interest rate. You’ll also usually be offered a higher rate if you have more money to deposit or if you sign up for a longer-term CD.

If you’re considering opening a CD at a new financial institution, it’s a good idea to read reviews of their customer service, or even call them yourself to see how easy they are to get a hold of and work with. You don’t want to sign up for a high-interest account with a bank that has sub-par customer service.

How much do I need to open a CD?

The amount you need to open a CD depends on the bank or credit union and the type of CD you want to open. Before shopping around, it’s a good idea to look at your finances and come up with an amount you are comfortable depositing. Remember: most CDs charge a penalty if you withdraw before the term ends, so it’s important that you’re confident you can leave the money untouched for the term.

What if I need to withdraw money early?

If you think you may need to withdraw money early, make sure you ask your financial institution about their early withdrawal penalties. You can also ask whether they offer a no-penalty CD, which will allow you to withdraw your money without paying a fine. But bear in mind that a no-penalty CD will likely have a lower interest rate than a traditional CD, so you’ll make less money over time.

Are CDs a good investment?

In general, CDs are a good investment. They are low risk compared to investing in stocks and bonds and they offer higher interest rates than typical savings or money market accounts. 

However, if you want the potential of a higher return on investment, you’re better off investing in stocks and bonds over the long term. That’s why most retirement accounts operate this way rather than like a CD. If your goal is to build up money over your lifetime for retirement, a CD can be part of your financial plan but shouldn’t be your only type of savings account.

What happens at the end of the CD’s term?

When you reach the end of the agreed-upon term, you will have a certain amount of time, usually around a week, to withdraw the funds. If you don’t withdraw the money during this period, the CD will often automatically renew for the same term as the original, and you will again be unable to withdraw the money without paying a penalty.

When your CD matures, it’s a good idea to look around at other CDs during that withdrawal period to see if you can get a better rate elsewhere. You may find that your current interest rate is the best, and you can leave your money in to renew for another term. But if you find a better rate at another institution, you can move the money there and open a brand-new CD instead.

Summary

If you’re looking for a better interest rate than your traditional savings account and have a lump sum to save, a CD is a good investment. They don’t carry the same risk associated with investing in stocks and bonds, but because they have a set term during which you can’t withdraw money without a penalty, banks and credit unions will offer a higher interest rate than they would with a savings or money market account. Shop around for the best rate available to you to make sure you’re getting the most return possible on your investment.

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