How Does a CD Work?

A certificate of deposit, also known as a CD, is a type of bank account that involves placing a deposit with a financial institution for a certain amount of time, and generally pays higher interest than a basic savings account.

But how does a CD work? We'll break it down.

What is a CD?

Certificates of deposit, commonly known as CDs, are time-bound investments that require you to deposit a sum of money for a fixed amount of time, ranging from a few months to several years. 

They are safe investments, insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000 per depositor, per bank. CDs are a perfect investment option for those looking to earn higher interest rates without incurring risks associated with the stock market.

How do CDs work?

CDs work by depositing a sum of money with a bank for a set period and earning interest on that money. The interest rate on CDs varies based on the term or length of the CD. Terms can range from as little as three months on the short end to as high as seven years or more on the long end.

Terms lengths of CDs

Generally, longer-term CDs tend to offer higher interest rates than shorter-term CDs. The interest accrues monthly or annually, depending on the terms of the CD. If you withdraw your money before the CD matures, you might be charged a penalty.

CD maturity

When you reach the end of the CD term, the CD is considered matured and you may withdraw the funds or place them into a new CD as you see fit. Typically, longer-term CDs offer higher interest rates, but this depends on the bank.

CD interest rates

Interest rates are usually locked in for the full length of the CD term, which can be a good or a bad thing, depending on what rates are doing at the time.

If rates are decreasing, locking in your CD rate can be a good thing, because it means you can earn a higher interest rate than you with a high-yield savings account, for example, where interest rates can fluctuate. But if you open a CD when rates are rising, you could get stuck earning a lower interest rate.

CD ladders

To combat this risk, some people employ a CD laddering strategy. To do this, you break up the amount you were going to invest in a single CD into chunks and invest them into CDs of differing lengths. For example, you could break up $5,000 into five $1,000 chunks and invest one chunk each in a one-, two-, three-, four-, and five-year CD. 

When the one-year CD matures, you place that money in a new five-year CD, then do the same thing the next year with the two-year CD, and so on. This enables you to take advantage of higher interest rates on longer-term CDs while still giving you access to some of your money every year.

How interest is paid

Interest is usually paid monthly or quarterly, and some banks let you decide if you want the interest paid directly to you or added to the CD. Keeping the money in your CD is your best option if you're trying to earn the most money overall, because when you earn the next interest payment, it'll be on your new, larger balance.

Taxes on CDs

Your CD earnings are taxable, even if you cannot actually spend those earnings yet. Your bank or credit union will send you a 1099-INT form by January 31 of the next year if your CD earned at least $10 in interest during the year. If not, you still owe taxes on the interest, but you are responsible for reporting those earnings yourself.

Automatic renewal

Once your CD term is up, your bank may choose to place the funds in a new CD automatically if you don't give it other instructions. This is usually a bad option, because the CD the bank chooses might not be the best one for you at the time.

So before your CD term is up, you should instruct the bank on what CD you'd like to place your money in, or whether you'd like the money paid to you.

Withdrawing money from CDs

If you withdraw the money before the CD term is up, you will pay a penalty. This penalty is usually equivalent to one or more months of interest, but it depends on the CD you choose and how early you withdraw the funds. Some banks may also impose a minimum penalty. You must withdraw all of the funds in the CD at once -- you cannot leave some there to continue earning interest.

Compare CD Rates

How much interest can you get from a CD?

The interest rate paid by a CD depends on a few factors. For one, overall financial market conditions tend to influence CD yields. Specifically, if the Federal Reserve raises interest rates, CD yields will generally rise across the board. On the other hand, when the Federal Reserve lowers interest rates, CD yields tend to fall.

Having said that, the type of financial institution offering the CD also plays a big role. Brick-and-mortar banks tend to have lower CD yields than credit unions, for example. And, online financial institutions tend to have the best CD yields of all.

Additionally, it's important to mention that CDs offer compounded interest throughout the term. For example, let's say that you deposit $1,000 in a five-year CD that has an annual percentage yield of 3%. This means that at the end of the first year, your CD would be worth $1,030. Then during the second year, you would earn 3% on $1,030. Over time, this can really add a significant amount to your returns if you choose a CD with a longer maturity.

CDs as retirement investments

It's also important to mention that you can hold CDs in certain retirement accounts, such as individual retirement accounts, or IRAs. If you put your money in a CD with a bank, the interest your account earns is generally considered taxable income.

However, if your CD is held in an IRA or other tax-advantaged retirement account, you won't have to worry about paying tax on the interest you receive on an annual basis. If you invest in a CD through a tax-deferred retirement account like a traditional IRA, your account deposit may be tax deductible, and you won't have to worry about any income taxes on your interest income until you make a withdrawal from the account. Or, if you invest through an after-tax account like a Roth IRA, your contributions won't be deductible, but qualified withdrawals from the account (including your interest income) will be 100% tax-free.

Is there any risk involved with opening a CD?

If we're defining risk as the potential loss of your deposit, the answer is almost certainly no. Bank CDs are FDIC-insured up to $250,000 per depositor, per institution. And credit union CDs are also insured through the National Credit Union Administration with the same limits.

In other words, if your bank goes out of business, these insurance programs guarantee the money in your account will be safe. If you have more than $250,000, you can still be fully insured by opening CDs at several different institutions.

Having said all of that, there's another type of risk to mention that is very important to understand before opening a CD -- interest rate risk.

Interest rate risk

Let's say that you open a five-year CD with an APY of 3%. If the market interest rate spikes to 6% a few months after you open the account, you're locked into the lower 3% rate for several more years. Meanwhile, if your money had been in a savings account, the interest rate you get paid generally rises and falls with the market rates over time.

One way to avoid this is by creating a CD ladder, which involves depositing your money into multiple CDs of varying maturities. For example, if you have $5,000, you might deposit $1,000 into a 12-month CD, $1,000 into a two-year CD, and so on. This way, one-fifth of your money will be available every year, which can then be invested at the then-current long-term CD rates.

Related: Can You Lose Money in a CD?

What if you need the money sooner?

To be clear, you are allowed to withdraw money from your CD whenever you want. However, if you choose to do so before the maturity date is reached, you'll typically be charged an early-withdrawal penalty.

In most cases, the early-withdrawal penalty for a CD is based on the interest rate you receive and the stated term length of your CD. Using Marcus by Goldman Sachs as an example, here's that institution's early withdrawal penalty structure:

Is a CD right for you?

It's a smart idea to keep some of your assets in cash, and a CD can be a smart way to do that if you're reasonably certain that you won't need to access the money for the entire maturity length. Emergency savings or money you'll need to cover day-to-day expenses is usually better off in a standard savings account.

Before you deposit money into a CD, it's important to shop around for the best possible yield, as there can be big differences between financial institutions.