How do CDs work?

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Certificates of deposit (CDs) are bank deposit products that hold your funds for a set period of time, or term. In exchange, the bank pays you a fixed annual percentage yield (APY), making CDs a safe, reliable way to grow your money.

CDs often earn higher interest rates than savings accounts and money market accounts, but they aren’t as liquid. When you open a CD, you agree to leave the money untouched for the term or incur a penalty for withdrawing funds early.

You can open CD accounts at banks and credit unions. Credit unions refer to CDs as share certificates, but they’re much like bank CDs.

How CDs work

CDs offer a guaranteed return when you keep your money in the account for a set term.

Let’s say you find a bank that offers a one-year CD with a 4 percent APY. As long as you keep the funds in the CD for the duration of the one-year term, you’re guaranteed to earn a 4 percent yield on your money. In the past, longer terms often earned higher APYs than shorter ones, although many shorter terms are currently outearning longer ones. Banks may also offer higher, promotional rates on specific terms.

If you withdraw the funds before the CD term ends, you can expect to pay an early withdrawal penalty, which can eat into your earnings.

When the CD reaches its maturity date, you can redeem it for your initial principal investment, plus the interest it earned. Banks usually offer account holders a seven- to 10-day grace period to move their funds out of a CD.

If you do nothing before the grace period ends, the CD typically will automatically renew at whatever APY the bank is offering for the product at that time. As such, the new APY could be higher, lower or the same.

There are many types of CDs, and it pays to become familiar with them if you want to find the one that best fits your goals.

CD basics: Important factors to consider

There are several factors to consider when shopping for a CD. Here are some key aspects to keep in mind.

CD rates

One of the first things to look at when opening a CD is the APY. The APY determines how much you’ll earn from the account. Higher APYs mean you’ll earn more money.

Rates on CDs are influenced by a number of different factors, including the term length, whether the bank has any promotional rates and what’s happening in the macroeconomic environment. Federal Reserve rate hikes, for example, have led to significant increases in yields on CDs.

The bank you choose can make a big difference when it comes to APYs. Online banks usually pay higher yields than brick-and-mortar banks. The national average yield for one-year CDs is 1.73 percent APY, according to the latest Bankrate data, while some of the best online one-year CDs are paying over 5 percent APY.

CD terms

The most common CD terms are three, six, nine, 12, 18, 24, 36, 48 and 60 months. But it’s possible to find shorter and longer terms. Some banks and credit unions issue CDs with unconventional terms, such as seven, 13 or 17 months. These terms may be specialty or promotional terms.

Savers can build a CD ladder by buying multiple CDs that mature at different times.

CD maturity date

The end of a CD term is called the maturity date. When the CD matures, you have the opportunity to do one of several things:

• You can simply let the bank renew the CD at its current APY for that product.The new rate might be different from the rate you got when you first opened the account.
• You can withdraw your principal, plus interest, and put the money into a new CD, or even a different type of CD, such as a no-penalty CD.
• You can withdraw your principal and interest and put the money into a different bank account, such as a savings or checking account.
• You can withdraw your principal and interest and put it into other investments such as stocks and bonds.

CD penalties

A CD is a time deposit account, so you’re making a commitment to keep your money in the CD for a set length of time. If you want to take money out of your CD before it matures, you’ll pay an early withdrawal penalty.

At many banks, the early withdrawal penalty is based on the amount of interest you earn in a day. Typically, CDs with longer terms will charge higher penalties.

• Example of Bank of America's CD early withdrawal penalties

  • For CDs with terms shorter than 90 days, all interest earned on the amount withdrawn or seven days’ worth of interest on the amount withdrawn, whichever is greater.
  • For CDs with terms ranging from 90 days to 12 months, an amount equal to 90 days’ worth of interest on the amount withdrawn.
  • For CDs with terms from 12 months to 60 months, an amount equal to 180 days’ worth of interest on the amount withdrawn.
  • For CDs with terms greater than 60 months, an amount equal to 365 days’ interest on the amount withdrawn.

CD types

There are many varieties of CDs, giving savers lots of options for managing their money. Here’s a quick look at some of the most common types of CDs.

CD safety

Like savings accounts, CDs are safe investments. They are federally insured when they’re offered from banks insured by the Federal Deposit Insurance Corp (FDIC) or credit unions insured by the National Credit Union Administration Share Insurance Fund (NCUA).

Insurance limits are $250,000 per depositor, per insured bank, per ownership category. So as long as your balance doesn’t exceed those guidelines, you won’t lose money if the insured bank or credit union closes or is otherwise unable to return your deposit. If you’re looking to deposit more than the amount covered, consider spreading funds across multiple banks to insure the full amount.

How to open a CD

Opening a CD, whether at a bank or credit union, involves choosing a type of CD, picking a term that meets your financial goals and then funding the CD.

Like with any financial product, you’ll need to show the bank or credit union that you are who you say you are in order to open an account. You’ll generally need to have this information to open a CD:

• Your Social Security number (or Individual Taxpayer Identification Number)
• A valid ID, such as a driver’s license
• Your date of birth
• A physical U.S. address
• A phone number
• An email address
• Enough money to meet the bank’s minimum opening deposit for the account

Then, you’ll fill out the application to open the product.

How much should you invest in a CD?

The amount of money you decide to park in a CD depends on your financial situation, goals and timeline.

Connecting the maturity of a CD to an upcoming event or goal in your life can help you determine what’s best. Let’s say you want to make a down payment on a house in a year. Putting your money in a 12-month CD would earn you interest and keep you from touching your house fund for a year.

CDs usually have minimum deposit requirements that vary among banks. Some banks, like Ally Bank and Capital One, have no minimum deposit requirements for CDs. Others, like Quontic Bank and Marcus by Goldman Sachs, require only $500 to open a CD.

Jumbo CDs require much bigger deposits, some as high as $100,000 or more.

Just be careful not to put all of your money in CDs. High inflation reduces the purchasing power of money that is earning a yield below the rate of inflation. Plus, it’s important that you keep some money in more liquid accounts, including checking and high-yield savings accounts.

What happens when my CD matures?

CDs mature on a specific date. At maturity, you can collect the principal amount and the interest earned, but the process varies by institution. It’s important to ask your bank or credit union how it provides notice that your CD is maturing.

As to what happens to your CD if you don’t take action when it matures, the rules vary by bank or credit union. Most institutions give you a window of time to act, called a grace period.

If you do nothing before the grace period is up, the bank might automatically renew the CD for the same term but at a different APY. That APY could be lower than the one you had when you first opened the account.

The frequency of interest payments on CDs varies by institution, as well. Keep in mind that while interest might be compounded on a daily, monthly, quarterly or yearly basis, it might be paid out to your account on a different schedule.

Bottom line

CDs are a reliable investment option for savers looking for a guaranteed return with minimal risk. They’re often federally insured and offer predictable yields over a fixed term. However, they don’t offer much room for liquidity, so it’s important to know what you’re committing to when you open a CD.

Make sure to shop around for a high-yielding CD at a term that fits your needs.

— TJ Porter and Libby Wells wrote a previous version of this story.