What Is a Certificate of Deposit and How Does It Work?

certifcate of deposit

A certificate of deposit is a type of savings account that typically offers a fixed interest rate and a higher rate of return than a traditional savings account. Your access to the funds will be limited for a set period; however, the benefits are that your money is federally insured and you can receive higher earnings from the interest.

Depending on which financial institution you bank with, your bank or credit union’s CD products might also be referred to as:

  • Term certificates
  • Term CDs
  • Savings certificates
  • Time deposits

A number of different types of CDs are available, as well as various strategies to maximize your earnings. So before you tie up your extra cash in a CD, learn about all the options to find out which CD might be right for you.

What Is a Certificate of Deposit?

A certificate of deposit is a safe, income-generating investment, as the funds are insured by the Federal Deposit Insurance Corp. up to $250,000.

Typically, a CD matures between six months and five years, although CDs come in shorter variations (like three months) as well as longer ones (like 10 years).

Good To Know

CDs are ideal if you have extra cash that you won’t need for an extended period and want to earn more interest than you would from a money market or savings account without having to risk the principal investment.

CD rates change, so be sure to check current rates before you make your decision.

Choosing a CD Account

First, you’ll need to determine which bank you want to use for your CD account. When considering banks, compare interest rates and maturity times to make sure you’re getting the most out of your CD.

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Most banks will have a minimum amount you can place into a CD, which can vary with the term of the CD and the interest rate. For instance, a bank might offer:

  • A 12-month CD at 1.05% APY; minimum: $5,000
  • A 24-month CD at 1.10% APY; minimum: $6,000
  • A 36-month CD at 1.15% APY; minimum: $7,000

You’ll decide how much you want to deposit into the CD, open the CD account and then deposit the money. That money will stay locked in for the entire duration of the CD. Once the CD expires, the money will return to you — along with the promised interest.

How Is a CD Different From a Savings Account?

A CD differs from a traditional savings account in two primary ways.

Withdrawal Restrictions

CDs may charge significant penalties if you take out the money before its maturity date, ranging from a few months’ interest to all of the interest earned. Savings accounts don’t usually have the same withdrawal restrictions as CDs. You can access the money whenever you’d like, but many banks prohibit more than six transactions of a certain kind each month.

Higher Interest Rates

CDs often pay more in interest, although online savings accounts are becoming quite competitive with CD rates. In many instances, you can earn more by locking your money in a CD than you can by investing in a more liquid savings account.

Keep in Mind

Long-term CDs typically pay higher rates than short-term CDs, but there’s a catch: If rates increase while you’re invested in a long-term CD, you’re essentially stuck with the rate you have until maturity. Although you can take out your money at any time, you’ll get hit with the early withdrawal penalty, which varies from bank to bank.

Why Would You Open a Certificate of Deposit?

A GOBankingRates survey found that more than half of the respondents didn’t know which bank products typically offer the best interest rates. Less than one-third selected the correct response and said CDs generally offer the highest rates.

Which Banking Product Typically Has the Highest Interest Rate?

CDs can be considered a good investment for those looking for low risks and steady returns. Here are the major benefits of a certificate of deposit:

CD Benefits

  • Low Risk
    CDs don’t fluctuate. As long as you keep your money in one, you’re guaranteed the interest.
  • Government Guarantee
    CDs carry insurance of up to $250,000, like savings and checking accounts.
  • Steady Returns
    Some CDs pay a very competitive rate, especially when compared with other guaranteed accounts like savings accounts. You can use a CD rate calculator to compare the options.

As for how much money you should put in a CD, it depends. Limit your investment to the amount you don’t need to keep liquid. While interest rates for CDs are lower in 2020 than they have been in the past, they are still generally higher than interest rates on savings accounts.

However, while CDs are the best option if you want higher interest in exchange for liquidity, high-yield savings accounts may be better if flexibility is important. And if you don’t need liquidity for a while, bonds and stocks may be better yet.

What Are the Types of CDs?

Almost as many types of CDs exist as there are types of savers. Use this guide to help narrow your search and find the type of CD that will best suit your financial goals.

Here are some of the types of CDs that are available:

  • No-penalty CD: No fee charged for early withdrawal but usually pays a lower interest rate
  • High-yield CD: Offers some of the highest interest rates available on the market, but usually with a longer term
  • Jumbo CD: Requires a larger investment (usually $100,000 minimum) but pays higher interest rates
  • Bump-up CD: Allows you to bump up to higher market interest rates if rates go up, but usually, only one rate increase is allowed
  • Step-up CD: Allows you to lock in your interest rate for a period, and your rate will increase over the term
  • Brokered CD: Offered by a stockbroker, online brokerage or other investment professionals, with a flat fee or percentage of investment amount often charged

The intricacies of each CD account will depend on the managing institution.

CD Strategies

If you’re looking for a little more bang for your buck when it comes to investing in CDs, consider a CD investment strategy. Rather than simply buying a single CD, you can invest in a range of CDs to help you achieve your investment goals.

Three strategies in particular — the CD ladder, CD barbell and CD bullet — offer different ways to enhance the return on your CDs.

CD Laddering

Americans Aren't Taking Advantage of CD Ladders

CD laddering is a way to keep your investment somewhat liquid and can result in higher growth rates.

To create a CD ladder, divide up your total investment into smaller sums, buying CDs of varying terms. For example, instead of buying one CD worth $30,000, you might buy three $10,000 CDs — one each at six-, 12- and 18-month terms. By doing this, one-third of your money becomes liquid every six months.

In addition to added liquidity, this strategy also allows you to maximize interest rates because, upon the second round, you are always investing in longer-term CDs.

  • Pros: You can maximize your CD interest rates while still having liquidity.
  • Cons: You’ll be locking a lot into CDs, which are still low revenue compared to stocks or bonds.

CD Barbell

Under the CD barbell strategy, you put half your investment into short-term CDs and half into long-term CDs. With this strategy, you’ll have some flexibility with the short-term investments while getting better interest yield with the longer-term accounts. Overall, you’ll get a medium yield average.

  • Pros: You maximize interest without sacrificing flexibility.
  • Cons: You don’t make as much as you would in solely long-term CDs.

CD Bullet

Another strategy is a CD bullet, in which you buy CDs that have the same maturity date at different times. So, the first year, you buy a 10-year CD, the second year you buy a nine-year CD, and so on.

  • Pros: You’re able to avoid interest-rate fluctuations.
  • Cons: You have to do more management all at once, and you may not make as much as buying longer-term CDs.

Are CDs Safe?

Like many other financial vehicles, CDs are FDIC insured up to $250,000; you can’t lose money in a CD any more than you can in a savings account. Because they come with a guarantee, they are as safe as a checking account or savings account.

The risk inherent to CDs is that you may need to cash them out before the term expires; if you do so, you could lose a significant amount of the interest you had gained.

Key Takeaways on CDs

CDs are a type of high-interest time deposit account. By setting aside money for a specified period, you can yield greater rewards than if you simply put the money in a savings account.

Takeaways

  • CDs typically offer higher interest rates than most savings accounts.
  • In exchange for high interest, CDs require you to keep your money in the bank for a specified term.
  • There are a few strategies, such as CD laddering, that can be used to increase the utility of CDs.
  • CDs, like saving and checking accounts, are protected by the FDIC.

John Csiszar contributed to the reporting for this article.

This article has been updated with additional reporting since its original publication.

Our in-house research team and on-site financial experts work together to create content that’s accurate, impartial, and up to date. We fact-check every single statistic, quote and fact using trusted primary resources to make sure the information we provide is correct. You can learn more about GOBankingRates’ processes and standards in our editorial policy.

About the Author

Terence Loose is an award-winning freelance writer who writes about everything from travel and sport to fitness and finance. He is a Hawaii-based writer who has covered a broad range of topics during his 20-plus-year career, from finance and education to travel and celebrity. He is a former editor for both Movieline and COAST Magazines and his work has appeared in publications as diverse as COAST, Riviera and Movieline to the L.A. Times Magazine and Orange County Register.