How Do CDs Work? Understanding the Basics of Certificates of Deposit
JUMP TO Section Chevron icon It indicates an expandable section or menu, or sometimes previous / next navigation options.- How CDs work
- Mechanics of CDs
- CD types
- Benefits of opening a CD
- What to consider for CDs
- Opening a CD Account
- FAQs
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- CDs earn interest by keeping money in the account for a set time period.
- Traditional CDs are the most common account available, but some banks also have specialty CDs.
- CDs have several features to assess, including interest rates and early withdrawal penalties.
Making informed financial decisions often begins with understanding your options. A certificate of deposit (CD) is one banking tool you can use to grow your savings.
We'll cover everything you need to know about these accounts so you can understand how CDs work, including diving into specific features such as CD rates, types, opening requirements, and penalties.
How do CDs work?
Definition of CD
CDs are interest-earning bank accounts. CDs work by paying you interest on the money in your account.
Christopher Stroup, CFP and financial advisor at Abacus Wealth Partners, says a CD may be a good place to store emergency reserves. Stroup also recommends that people match a CD with a specific savings goal. When choosing a CD, think about which features can help support your goal. One way to narrow down your options is to consider how long you can keep money in the account without needing to make a withdrawal.
How CDs differ from other savings accounts
CDs differ from other savings accounts because you have to keep money locked in for a period of time. You'll only be able to make a deposit when you first open a CD. You also won't be able to make any penalty-free withdrawals until your term ends.
In comparison, savings and money market accounts let you deposit or withdraw money at any time. Some banks have free monthly withdrawal limitations, though.
Per Regulation D, banks may penalize consumers for withdrawing from savings more than six times a month. That said, the Board of Governors of the Federal Reserve amended Regulation D during the COVID-19 pandemic. Banks can enforce a six-per-month transaction limit, increase the withdrawal limit, or delete it so customers can make unlimited transfers and withdrawals from their savings accounts.
Mechanics of CDs
CD rate fluctuations
CD rates fluctuate over time and vary widely across financial institutions. You'll see CD rates go up and down over time because they're influenced by changes in the federal funds rate. When the Federal Reserve cuts the federal fund rate, CD rates drop. When the Federal Reserve raises the federal funds rate, CD rates rise.
CD terms
CDs are open for a term. A term is how long you'll keep money in an account and earn a fixed interest rate. For example, if you open a 1-year term, you would earn the same interest rate for 12 months.
Most financial institutions offer traditional CDs for terms between six months and five years.
CD maturity
Once your CD term is about to end — or "reach maturity" — you'll have the option to make changes to your account. This is referred to as a grace period by financial institutions. The grace period for a CD usually lasts around 10 days.
You'll have the option to withdraw money or close an account. If you'd like to keep money in a CD, you could also choose to renew the term.
CD types
Here's a brief overview of the different types of CDs and their features The most common type of account you'll find is a traditional CD. However, many financial institutions also have specialty CDs — unique variations of the standard account option. Also, take note CDs do not have any monthly bank maintenance fees.
| Type of CD | How it works |
Traditional CDs | It permits a one-time deposit. A financial institution pays the same interest rate on your account for the entire term. If you withdraw money before the term ends, the bank charges a penalty. |
| It has the same features as a traditional CD, except it pays a higher rate with the requirement of a higher opening deposit (often $100,000 or more). | |
| This is a type of retirement investment account. There are traditional, Roth, and SEP IRA CDs. IRA CDs have many of the same rules as other IRAs. | |
| It's available at a brokerage firm. They don't compound interest and or have early withdrawal penalties. If you want to withdraw money early, you have to sell it in a secondary market. | |
| This CD does not charge any penalties for early account withdrawals. It still has a fixed interest rate and only permits a one-time deposit. | |
| This is the only type of CD that permits additional deposit after opening an account. It still has a fixed interest rate and early withdrawal penalties. | |
Variable-rate CDs | It has an interest rate that changes during the term. These CDs only permit a one-time deposit and have early withdrawal penalties. Some examples of variable rate CDs include step-up CDs and bump-up CDs. |
Benefits of opening a CD
Federal insurance for CDs
CDs are safe, low-risk savings options because they are offered by federally insured banks and credit unions. If a financial institution is federally insured, up to $250,000 per depositor, per account category is secure in a bank account. If a bank or credit union collapses, your insured deposits are protected by the FDIC or NCUA.
If you want to deposit more than $250,000 in a CD, there are still ways to make sure your money is protected and insured. You could open an individual bank account and a joint bank account at the same financial institution. Another option is to open bank accounts at different banks and credit unions. Keep in mind there are benefits and drawbacks to opening a joint bank account versus an individual account or opening bank accounts at multiple banks.
Fixed interest rates
Most types of CDs offer a fixed interest rate. This means the rate will stay the same for the term. For example, if you opened a 1-year CD paying 5% APY, you'd earn 5% APY for 12 months — it wouldn't increase or decrease during that time.
If you open a variable-rate CD, the interest rate on your account may fluctuate over time. These CDs may offer a guaranteed rate increase at a specified date, require you to request a rate change, or alter the rate automatically according to the federal funds rate.
Key considerations before opening a CD
Interest rates vs. inflation
CDs normally don't offer enough interest to beat inflation. They are more of a savings option instead of a long-term investment.
One way to protect yourself against inflation is to invest in stocks, bonds, and other assets that offer higher returns. However, keep in mind that there's a greater risk involved when you invest in the stock market than when you deposit money in a bank account.
Experts generally recommend saving money for short-term goals. If you saving for a long-term goal that's longer than five years, you might consider investing instead.
Note: The most competitive CD rates and savings rates are beating inflation because rates increased significantly throughout 2022 and 2023. It isn't likely to stay that way, though. The Federal Reserve anticipates rate cuts in 2024, and CD and savings rates are expected to go down too.
CD early withdrawal penalties
If you need to take out money from a CD before the term ends, most types of accounts charge an early withdrawal penalty. The penalty for an early withdrawal is often paying back some of the interest you earned.
Stroup says one strategy used to offer more liquidity is creating a CD ladder. You can build a CD ladder by splitting your deposit into multiple CDs of different terms instead of putting it all into a longer-term CD and risk needing to withdraw funds early.
"In terms of maintenance with the CD ladder, one of the things the consumer may want to be mindful of are those maturity dates," adds Stroup.
Stroup recommends checking in with your financial goals when each CD is about to reach maturity and seeing if you want to reinvest or withdraw your money. You might decide you need to have access to more cash, then move the money to a savings or checking account.
Taxes on CDs
CDs are taxable, and you'll report interest earned on your account when you complete your annual tax return.
Financial institutions will send a 1099-INT form by January 31 if you earned more than $10 in interest. If you do not pay taxes on CDs, you may face a penalty by the IRS.
Opening a CD Account
CD opening requirements
The process for opening a CD is pretty straightforward. You can open an account at a bank, credit union, or brokerage firm. You must be at least 18 years old to open an individual bank account. If you're getting a CD for a minor, a legal guardian or parent can open a joint bank account with the child.
When you open a CD, you will need to provide personal information and documentation, like a government ID, Social Security number, and proof of address. There are also banks and credit unions that make it easy for immigrants and non-US citizens to open an account.
The standard minimum opening deposit for CDs is $1,000. However, select financial institutions let you open a CD with $0.
What to look for in a CD
When you're looking a CDs, review key features like interest rates, minimum opening deposit requirements, and early withdrawal penalties before you open an account.
If you're considering a CD from a bank or credit union you've never heard of before, check to make sure the financial institution is FDIC or NCUA-insured. The FDIC has a search tool that allows you to search for institutions by name or location. The NCUA also has a similar search tool on their website.
How CDs work FAQs
How do CDs make you money? Chevron icon It indicates an expandable section or menu, or sometimes previous / next navigation options.CDs make you money by paying interest on funds that are kept in the account.
How are interest rates for CDs determined? Chevron icon It indicates an expandable section or menu, or sometimes previous / next navigation options.Individual banks will determine the interest rate for their CDs, although economic conditions may also impact rate fluctuations. When the Federal Reserve cuts the federal funds rate, the rate of CDs across many financial institutions may also drop. When the Federal Reserve raises rates, CD rates tend to rise as well.
How do I choose a good CD? Chevron icon It indicates an expandable section or menu, or sometimes previous / next navigation options.Choosing a CD depends on the timeline of your goal and what you're saving for. It may be worth putting money into a CD if you do not need immediate access to some of your savings, but you may prefer another type of savings option if you need more accessibility.
What is the total amount of interest a $10,000 CD makes in a year? Chevron icon It indicates an expandable section or menu, or sometimes previous / next navigation options.If you deposit $10,000 into a CD for a year, the amount of interest you'll earn will depend on the current rate and how frequently the interest is compounded on the account. That said, if you deposited $10,000 into a 1-year CD paying 5.50% APY, you'd make about $550 in interest.
What is the total amount of interest a $5,000 CD makes in a year? Chevron icon It indicates an expandable section or menu, or sometimes previous / next navigation options.If you deposit $5,000 into a CD for a year, the amount you'll make will depend on the current rate and how frequently the interest is compounded. If you deposited $5,000 into a 1-year CD paying 5.50% APY, the total interest earned would be around $275.
Sophia Acevedo Banking Editor Sophia Acevedo is a banking editor at Business Insider. She has spent three years as a personal finance journalist and is an expert across numerous banking topics.ExperienceSophia leads Personal Finance Insider's banking coverage, including reviews, guides, reference articles, and news. She edits and updates articles about banks, checking and savings accounts, CD rates, and budgeting and saving. She is highly knowledgeable about long-term trends in rates and offers at banks across the U.S.Before joining Business Insider, Sophia worked as a journalist at her college newspaper and was a freelance writer. She has spent seven years writing and editing as a journalist.Sophia was nominated for an Axel Springer Award for Change in 2023 for her coverage of ABLE accounts, tax-free savings accounts for people with disabilities. She was also a winner of a 2018 California Journalism Awards Campus Contest for her photography.She loves helping people find the best solutions for their unique needs and hopes that more people will find the tools to solve their financial problems. She’s inspired by stories of everyday people adapting to their financial circumstances and overcoming their fears around money.ExpertiseSophia's expertise includes:- Bank accounts
- Savings and CD rate trends
- Budgeting
- Saving
- How banks operate
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