CD stands for Certificate of Deposit

A Certificate of Deposit is a savings product where you give a bank a lump sum of money and agree to leave it untouched for a set period of time. In exchange, the bank pays you a fixed interest rate that is usually higher than what you would earn in a regular savings account. When the time period ends — called the maturity date — you get your original money back plus the interest you earned.

The bank uses your money during that locked-in period, which is why they pay you more interest than they would for money you could withdraw anytime. You are essentially lending the bank your cash for a may provide return.

Key Takeaways

  • A CD is a savings account where you deposit money for a fixed time period, typically ranging from three months to five years, and cannot withdraw it without a penalty.
  • Banks pay higher interest rates on CDs than on regular savings accounts because your money stays with them for a may provide length of time.
  • The interest rate is locked in when you open the CD, so you know exactly how much you will earn regardless of whether market rates go up or down.
  • If you withdraw your money before the maturity date, you will owe an early withdrawal penalty, which is usually a certain number of months of interest.
  • CDs are FDIC-insured up to $250,000 per depositor per bank, making them a low-risk way to save money.

How the time lock works

When you open a CD, you choose how long to lock your money away. Common terms are three months, six months, one year, two years, three years, and five years. Some banks offer terms as short as 30 days or as long as 10 years, but these are less common.

During the entire term, you cannot touch the money without paying a penalty. The penalty varies by bank and by term length — a three-month CD might charge one month of interest if you withdraw early, while a five-year CD might charge six months of interest. You need to read the CD agreement to know what your specific penalty is before you open the account.

On the maturity date, the CD automatically matures. At that point, you can withdraw your money penalty-free, or you can roll it into a new CD at whatever interest rate the bank is currently offering.

Interest rates and how they are set

The interest rate on a CD is fixed, meaning it does not change for the entire term. If you open a one-year CD at 4.5 percent, you will earn 4.5 percent for the full year, even if the Federal Reserve raises interest rates and banks start offering 5.5 percent on new CDs.

Banks set CD rates based on what the Federal Reserve is doing and what other banks are offering. Rates vary significantly between banks — a large national bank might offer 3.5 percent on a one-year CD while an online bank offers 4.8 percent for the same term. It pays to shop around before you open a CD.

Longer terms usually come with higher rates. A five-year CD will typically pay more than a one-year CD, because the bank gets to use your money for longer and you are taking on more risk that you might need the money before maturity.

The penalty for early withdrawal

If you need your money before the maturity date, you can withdraw it, but you will owe an early withdrawal penalty. This penalty is almost always expressed as a number of months of interest — not a flat dollar amount.

For example, if you have a $10,000 CD earning 4 percent annually and the penalty is three months of interest, you would owe $100 in penalties (three months of the $400 annual interest). You would receive $10,300 — your original $10,000 plus the interest you actually earned, minus the $100 penalty.

Some banks have different penalties depending on how early you withdraw. Withdrawing after 11 months might cost three months of interest, but withdrawing after one week might cost six months of interest. Always ask what the penalty structure is before you open the account.

FDIC insurance and safety

Money in a CD at an FDIC-insured bank is protected up to $250,000 per depositor per bank. This means if the bank fails, the federal government will reimburse you for your CD balance up to that limit. CDs are considered one of the safest places to put your money because there is no market risk — your rate is locked in and your principal is insured.

If you have more than $250,000 to deposit, you can open CDs at multiple banks to stay within the insurance limit at each one. Some people also use brokered CDs, which are CDs sold through investment firms, though these have different insurance rules and should be understood carefully before purchase.

CD ladders and how people use them

Because money in a CD is locked away, some people build a CD ladder to balance safety with access. A ladder means opening multiple CDs with different maturity dates — for example, one CD maturing in one year, one in two years, one in three years, and one in four years.

As each CD matures, you can withdraw the money if you need it, or roll it into a new longer-term CD. This way you are not locking all your money away for the same length of time, and you get to take advantage of higher rates on longer terms while still having some money available each year.

A CD ladder works best when you have a chunk of money you do not need immediately but want to earn more interest than a regular savings account would pay. It requires discipline not to withdraw early and pay penalties.

When a CD makes sense versus other accounts

A CD is useful if you have money you will not need for a specific period of time and you want a may provide return. If you know you will not touch the money for two years, a two-year CD will pay more interest than keeping it in a savings account.

A CD is not the right choice if you might need the money before maturity, because the early withdrawal penalty will eat into your earnings. It is also not ideal if you think interest rates will rise significantly, because your rate is locked in and you cannot take advantage of higher rates without paying a penalty to withdraw.

For money you need to access anytime, a high-yield savings account is better. For money you are investing for growth over many years, stocks or bonds might make more sense. A CD fits in the middle — it is safer than stocks but pays more than a regular savings account.

Frequently Asked Questions

Can I withdraw money from a CD before it matures?

Yes, you can withdraw anytime, but you will owe an early withdrawal penalty. The penalty is usually a certain number of months of interest and varies by bank and CD term. Check your CD agreement to know the exact penalty before you open the account.

What happens when my CD reaches maturity?

On the maturity date, your CD stops earning interest. You can then withdraw your money penalty-free, or you can roll it into a new CD at the bank's current rate. Some banks automatically roll CDs into new ones if you do not tell them otherwise, so check your account to see what will happen.

Is my money safe in a CD?

Yes, CDs at FDIC-insured banks are protected up to $250,000 per depositor per bank. Your principal and interest are may provide by the federal government, and there is no market risk because your rate is locked in from the start.

Do I pay taxes on CD interest?

Yes, CD interest is taxable as ordinary income in the year you earn it, even if you do not withdraw the money. The bank will send you a 1099-INT form at tax time showing how much interest you earned. Some people use CDs in retirement accounts like IRAs to defer taxes on the interest.

Why would I choose a CD over a savings account?

CDs pay higher interest rates because you agree to lock your money away for a set time. If you have money you will not need for months or years, a CD will earn you more than a regular savings account. The tradeoff is that you cannot access the money without paying a penalty.