How Do CDs Work? Understanding the Basics of Certificates of Deposit (2024)

Affiliate links for the products on this page are from partners that compensate us and terms apply to offers listed (see our advertiser disclosure with our list of partners for more details). However, our opinions are our own. See how we rate banking products to write unbiased product reviews.

• 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 Reserveamended 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.

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.

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