What is a certificate of deposit (CD) and how does it work?

What is a certificate of deposit (CD) and how does it work?

A certificate of deposit or (CD) is a savings product that offers a fixed interest rate for a set period of time, usually called the CD’s “term.” The most common terms for CDs are three months, six months, twelve months, two years, three years, and five years. Usually, the longer the term, the higher the interest rate offered. The annual percentage yield or APY of a CD is highly correlated to the interest rate set by the Federal Reserve, although banks set their own rates to compete for business. If you withdraw the money from the CD before the term has completed, you receive a penalty. CDs are a safe place to keep your money and gain a predictable, fixed interest rate. CDs are also fairly inflexible because of the penalty for removing the money before the CD fully matures.  

What to know before buying a certificate of deposit (CD)?

Consider the following things before buying a certificate of deposit:

Minimum deposit

Almost all CDs have a minimum deposit requirement. When you are thinking about putting your money in a certificate of deposit, you ought to think about how much you want to invest. 

Fixed interest rate

Certificates of deposit (CDs) offer a fixed interest rate. This means that the returns you will earn from putting your money in a CD will be predictable. Even if the market goes down, you can be confident about what you will receive. That sword cuts both ways, though. If CD rates go up, you will still have the rate you signed up with. 

Early withdrawal penalties

One of the reasons that banks or credit unions offer better interest rates on CDs than traditional savings accounts is because the money is committed to staying deposited for the length of the term. If you pull the money out early, the bank will charge you an early withdrawal penalty. That penalty is calculated as an amount of interest earned and is dependent on the length of the term. 

Required term

When you put money into a certificate of deposit (CD), you commit to leave your money in for a predetermined amount of time. Typical term lengths are 30 days, 3 months, 6 months, 12 months, 2 years, 3 years, and 5 years.   

Adding funds before maturity

Most certificates of deposit do not allow you to add funds except during a grace period before an automatic renewal. However, add-on CDs do allow you to add money. 

Automatic renewal

When a CD matures (and its term is up), many banks will roll over the funds into a new CD. There is usually a grace period before the automatic renewal is irreversible. After that time, withdrawing from the CD will incur an early withdrawal penalty.

Issuing bank or credit union

You do not need to have a current relationship with the bank or credit union to put money into a certificate of deposit, so it’s a good idea to shop around for the best rates and the terms that fit your lifestyle. Make sure that the bank or credit union that you select is federally insured so that you are protected against bank failure.

What is the typical term on a certificate of deposit (CD)?

The most common terms for certificates of deposit are:

• 3 months
• 6 months
• 12 months
• 2 years
• 3 years
• 5 years

What’s the difference between a certificate of deposit (CD) and a time deposit (or term deposit)?

A time deposit (also known as a term deposit) is very similar to a certificate of deposit (CD) in that a financial institution will offer a higher-than-usual interest rate in exchange for the promise to keep the money in an account, untouched, for a specified amount of time, also known as the term. 

What happens if you pull money out of a CD early?

Banks offer a higher interest rate for CDs because of the commitment that the money will stay in the account for a set amount of time. If you pull the money out of the CD before the completion of the term, the bank will fine you an early withdrawal penalty. The fee is usually charged on the amount that is withdrawn rather than the entire amount. 

How much interest do you lose if you close a CD early?

Early withdrawal penalties for CDs are always calculated in terms of interest, but will depend on the term of the CD. Withdrawing from a 30-day CD might cause a fee of 7 days of interest. Longer term CD’s penalty might be as much as 90 days interest. 

Are CDs a safe investment?

When it comes to the federally-insured deposits which protects consumers from bank failures (FDIC), CDs are categorized the same way savings accounts are. That means that as long as the CD was obtained from an FDIC insured institution, the CD will be insured up to $250,000. 

What are the different types of CDs?

There is a lot of variety when it comes to certificates of deposit (CDs). They each have slightly different features or benefits. Some of the different types of CDs include:

• Traditional CD: These are your run-of-the-mill, vanilla version of a CD, with a fixed interest rate for a fixed term. 
• Bump-up CD: A bump-up CD is very similar to a traditional CD, but you have the option once per term to ask the bank or credit union to bump up to an improved rate. This allows you to take advantage of environments where you believe the interest rate will be going up. The downside to this feature is that you will always be a little behind the best interest rates. You also have to ask for improvement and cannot ask repeatedly. 
• Step-up CD: Like Bump-up CDs, the step-up CD allows you to take advantage of a period of improving interest rates. The advantage of the step-up CD is that it will automatically adjust your rate as conditions improve. The downside is that the initial rates will almost always be lower than initial rates offered for traditional CDs. 
• IRA CD: An IRA CD is a traditional CD only if it is held in a tax-advantaged individual retirement account (IRA) and is used for retirement planning. 
• Callable CD: A callable CD gives the bank or credit union a bit more control. These CDs usually have a higher APY (annual percentage yield, or interest rate), but gives the institution the right to “call” the CD before the term is completed. You would still keep all the interest up to that point, but the CD would then be closed. Why would the bank close it early? Well, if interest rates drop, they may want to reset their financial exposure. 
• Add-on CD: With an add-on CD, you can continue to put money into the CD after you opened the account, but the terms and conditions might limit how often or how many times you can add money.
• Liquid CD (also known as a no-penalty CD): You trade off a lower APY for the right to withdraw money from the CD before the term without penalty. 
• High yield CD: High-yield CD maybe more of a marketing term than a meaningfully different product. It simply represents a CD with a higher-than-normal APY. When a CD becomes a high yield CD may be a matter for the marketers. 
• Jumbo CD: The jumbo CD refers more to the size of the deposit, usually at least $100,000. Jumbo CDs may receive a higher APY (as many CDs have a tiered benefit based on deposit amount), but not necessarily. 
• Zero-coupon CD: The zero-coupon CD doesn’t pay out interest during the term, but only as a lump sum when the term fully matures. Folding in the interest compounds the returns and often results in a higher total APY. 

What is the CD ladder?

The biggest drawback of a certificate of deposit is that the money is tied up until the end of the term. To make matters worse, you receive a better annual percentage yield (APY) for longer terms than for shorter terms. If you are uncomfortable locking up your money for extensive periods of time, the CD ladder might be the strategy to employ. 

How does the CD ladder work?

Instead of investing in a single CD with a two year term (for example), the CD ladder strategy would have you divide up the amount you want to invest in CDs into smaller amounts with terms that overlap with each other. Instead of all of your money in a single CD that you won’t have access to for 24 months, you might stagger out the CDs so you have a portion maturing every six months. This gives you the option to always have a portion of your money more liquid than it otherwise would, but still take advantage of the better rates found in certificates of deposit.

Example of a CD ladder

Suppose you have $30,000 that you would like to place in certificates of deposit so you are earning a better return than you would in a regular savings account. But, you are uncomfortable of losing access to all of that money for an extended period of time. Instead of investing all $30,000 in a CD with a 5 year term, you might select several CDs with overlapping terms:

If after six months, you find that you did not need the $5,000 that is maturing, you would move that amount into a new CD with a 5 year term. That means it will mature six months after the $10,000 CD. As each one matures, you can move it into a 5 year CD so that you get to a point where all of your CDs are taking advantage of a higher 5 year APY, but that each year a portion of your savings is available in case you want to do something different with it. 

Of course, the CD ladder can be done with long terms or short terms depending on your need for liquidity and flexibility. 

What are the advantages of CDs?

The three primary advantages of certificates of deposit (CDs) are:

1. Higher interest rates: You will receive a better savings rate with a CD than you will with a traditional savings account.
2. Predictability: The fixed APY (annual percentage yield, or interest rate you earn on the money) and the set term length of the certificate of deposit makes it one of the most predictable savings tools available.
3. Safety: Because they are insured by the FDIC up to $250,000, certificates of deposit are a safe place to put any savings that you might have.

What are the disadvantages of CDs?

The main disadvantages of putting your savings into a certificate of deposit are:

• Inflexibility: Putting money in a certificate of deposit locks the money in a set term which means that you have much less flexibility to use that money if something important comes up. 
• Early withdrawal penalties: If you need to pull money out of a certificate of deposit before the term is up, you will be fined an early withdrawal penalty which would eat into the interest you earned over that period. 
• Auto-rollover: Many certificates of deposit have automatic rollover features that move the money into another CD upon maturity. While there is a grace period that will allow you to opt out without a fee, if you aren’t paying attention, you might find your money getting locked away for another period of time. 
• Inflation risk: Because the APY (annual percentage yield) on certificates of deposit are fixed, you could find yourself earning an interest rate that lags current inflation, especially if macroeconomic conditions change fast. 

What is the average APY for CDs?

In the 1980s, the average certificate of deposit (CD) had a APY (annual percentage yield) of about 8%. During the 1990s, the average APY had dropped to about 5%. In the 2000s, average certificate of deposits APY had further dropped to 2%. Throughout the 2010s, the APY for certificates of deposit have consistently been below 1%. Due to rising interest rates, current certificates of deposit are hovering above 3% for the first time in twenty years. 

Of course, the range of options will depend on the terms of the CD and the issuing institution, but certificates of deposit do not currently offer interest rates that would be above the rate of inflation. 

Is it better to have a savings account or a CD?

If your only concern is getting a better annual percentage yield (APY), then a certificate of deposit is definitely a better option than a traditional savings account. However, if you rely on your savings account as a rainy day fund, to cover emergencies, or to allow you financial flexibility, a certificate of deposit is not a good place to store your money. CDs require you to leave the money untouched for the length of the CDs term. If you do withdraw it, you will be subject to an early withdrawal penalty. 

In most circumstances, it is better to establish a savings account that allows you the flexibility to use the money when you need it before you put money into a certificate of deposit. 

What is the difference between a CD and a savings account?

A certificate of deposit is a form of savings account that provides a fixed interest rate in exchange for a commitment to leave the money untouched for a set period of time. If you remove the money early, you will be hit with penalties. A CD also has higher minimum requirements. A savings account has much more flexibility to move money in and out of the account whenever you want, but the APY is significantly lower. 

What is the difference between a CD and a high-yield savings account?

A certificate of deposit is a saving product that offers a significantly higher interest rate than you would get in a traditional savings account. The interest rate is fixed for a set period of time, called the CDs “term.” If you remove the money from the CD before the term has completed, you receive a penalty which often wipes out any interest earned to that point. A high-yield savings account also offers a higher interest rate than you would get from a traditional savings account, but the interest rate floats based on other factors, like the federal fund rate. Also, a high-yield savings account allows you much more flexibility in accessing your money over time. 

What is the difference between a certificate of deposit and a money market account?

Certificate of deposit is a savings product that offers a better interest rate than a traditional savings account, because the APY (annual percentage yield) is fixed for a predetermined period where you are committed to keeping your money. The bank penalizes you if you remove the funds before the CD matures. Money market accounts are flexible accounts that act a little like a savings account with a few features common to checking accounts, like a debit card and the ability to write checks from the account. 

What makes CD rates go up and down?

The biggest influence on CD rates is the interest rate set by the Federal Reserve when they attempt to manage the economy. When the Fed increases interest rates, CD rates will typically also go up. Of course, because of the timing of CDs, it is not unusual for CD rates to take a few months to catch up.

Another thing that can influence the rate offered for CDs is the strategy of the bank issuing the CD. They may want more deposits and are willing to increase what they offer in order to acquire them. 

Why do banks have different rates for CDs?

Even though CDs APY is highly correlated to the interest rate established by the Federal Reserve, banks set their own APY for the certificates of deposit that they offer. A couple of things can influence how much of a return that they offer. First, if the bank has a high demand for deposits, they may offer a higher interest rate on their CDs. Second, the bank can set different profit targets for their products which can result in different interest rates than their competitors. 

It’s often constructive to see that a bank is like any business that must buy materials in order to make a product to sell at a profit. Only the bank sells the use of money in the form of things like mortgages, business loans, and auto loans. The materials that they need to issue those loans are deposits from things like savings accounts and certificates of deposit. 

Banks make a bigger profit if they can charge higher interest rates on the loans they give out and pay less to those who deposit their money with their institution. If there is a high demand for loans, the bank may need to increase the APY (annual percentage yield) that they offer in order to have more deposits that they can use to lend money. 

Another way to increase the supply of money is when the Federal Reserve lowers the “fund rate” of money. When interest rates drop, it is less expensive for banks can borrow money from the Federal Reserve.

How often do CD rates change?

Most banks will update their CD rates every business day.

Is a certificate of deposit the best way to build a savings?

A certificate of deposit isn’t necessarily a good tool for building savings so much as it is a good tool for protecting savings that has already been built. Also, storing a rainy-day fund in a certificate of deposit may mean that the money is locked in when you need it most. Check out our article on the best way to save money and build a savings.