What Is a CD?

A certificate of deposit (CD) is a special type of bank account that enables you to earn a high APY on your savings -- as long as you can leave the money untouched. Below, we explain how it works, the pros and cons, the types of CDs, and how to know if a CD is right for you.

Certificates of deposit, commonly known as CDs, are investment vehicles that offer higher interest rates than traditional savings accounts. Credit unions often call them share certificates. 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.

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CDs are ideal for those who want to avoid the volatility of the stock market and are looking for a predictable return on their investment. They are perfect for individuals with a low risk appetite and who want a stable source of income. Here are some of the key advantages of a CD:

• FDIC-insured: CDs are almost always FDIC-insured, so your funds are protected up to $250,000 in the event of bank failure. If you open a CD with a credit union, it may carry NCUA insurance instead, which is essentially FDIC insurance for credit unions.
• Widely available: CDs are available with most banks and credit unions. This ubiquity means a lot of competition, and that's good news for you. Banks will usually offer the best rates they can to encourage you to choose them over competitors.
• High APYs: You can earn a higher APY with a CD than you can with most other types of bank accounts, especially if you choose a CD with a longer term.
• Locked-in rates: This can be good or bad, but when rates are falling, the opportunity to lock in a higher interest rate could help you earn more than if you kept that money in a savings account.

Here are a few downsides to CDs you should bear in mind when deciding if this account type is right for you.

• Penalties for withdrawing money early: When you open a CD, you're tying up your money for months or even years, and you'll pay a penalty if you withdraw your funds early.
• One-time deposits and withdrawals: You cannot withdraw only part of your CD contributions, and you usually can't deposit more funds into an existing CD unless you choose an add-on CD.
• Locked-in rates: If interest rates rise after you've opened your CD, you're usually stuck at the lower interest rate for the remainder of the CD term.
• Lower returns: CDs' interest rates might be lower than other investment options like stocks and mutual funds, which could offer higher returns if invested wisely. If inflation rates exceed the interest rates on a CD, your returns might be eroded over time.
• Taxable earnings even if you can't access them: You still owe taxes on your CD earnings every year, even if you cannot actually spend that money yet.

If you don't think a CD is the right place for your money, here are a few other account types to consider.

High-yield savings account

High-yield savings accounts are usually offered by online banks. They're essentially the same as a regular savings account, except they offer a much higher interest rate, and some of them are comparable to CD rates.

Savings accounts limit you to six monthly transfers or withdrawals, but this is still much more flexible than CDs, which don't permit you to withdraw funds without penalty before the CD matures. You can also deposit money into the account at any time and this won't count toward your limit.

You can withdraw funds electronically or set up automatic bill pay. If your bank has branches, you can visit one to request your money, or use an ATM if your savings account includes an ATM card. Branches and ATM cards are rare with high-yield savings accounts, though, so you may have to transfer your money to a checking account before you can withdraw it.

Money market account

A money market account is similar to a savings account and offers high APYs that can come close to CD APYs. Money market accounts are subject to the same monthly withdrawal limitations as savings accounts, but they often come with checks and debit cards so you can withdraw funds directly from the account when you need them.

Money market accounts usually have higher minimum balance requirements than savings accounts, especially if they offer a high APY, so one of these accounts might be a better fit if you have a large sum to deposit and aren't willing to tie it up in a CD.

Generally, CDs are right for those who are looking for a low-risk investment option that will provide a guaranteed return over a fixed period of time. This makes CDs ideal for people who are risk-averse and prefer security over higher potential returns. 

Additionally, CDs can be a good choice for retirees and other individuals who are looking to generate passive income from their savings without taking unnecessary risks. While CDs may not offer the highest returns compared to other types of investments, they can provide a reliable source of income and peace of mind for those who prioritize security and stability in their financial planning.

A CD is a smart choice for money you don't expect to need in the next few months or years. You can earn a higher interest rate with a CD than you would with a savings account, but early withdrawal brings a penalty, so it's something you want to avoid. If you're not comfortable risking your savings in the stock market, a CD offers a guaranteed return and a locked-in interest rate for the full term.

CDs aren't a good place for your emergency fund or for money you think you may need to call upon before the CD term is up. Use a savings account or a money market account for these funds instead, so you have easy access to them when you need them.