What is a certificate of deposit (CD) and how does it work?

Widely considered low-risk investments, banks and credit unions typically offer CDs with competitive interest rates relative to the Federal Reserve’s benchmark funds rate in order to lure new customers. (See some of the best CD rates you can get here.) But unlike a savings account, CDs can charge a fee, or penalty, for making withdrawals prior to the previously agreed upon maturity date.

How a certificate of deposit works

Certificates of deposit are a time-bound deposit vehicle that pays investors an annual percentage yield, or APY, for the duration of the account. If the account goes untouched by the time it reaches its maturity date, then CDs pay out the interest earned over that period of time.  But withdraw the money before the maturity date is up, and you typically get hit with an early withdrawal penalty.

The life of a CD often ends at this maturity date, with some financial institutions giving customers the option to roll over their principal and interest earned into a new term. Others simply offer the opportunity to open a new CD. 

Certificate of deposit rates

Interest rates for CDs vary depending on the financial institution. Meanwhile, the real rate of return earned on a given investment, or APY, often correlates with the terms, with longer CD terms typically earning higher rates. (See some of the best CD rates you can get here.)

However, says Billy Cho, savings expert and Manhattan Market Leader at Citi, says that is not always the case. “Two of the main factors outside of term and duration that can impact your CD’s rates are the marketplace of the bank you’ve chosen, as well as any decisions about rate increases or decreases that come from the U.S. Federal Reserve.”

To be sure, the Fed has increased the benchmark funds rate to 5%-5.25% in June from nearly zero a year ago in its effort to combat rising inflation. As a result, CD rates have also increased, making them more lucrative for savers. CDs with 12-month maturity dates, for example, have grown to an average of 1.72% APY through July 17, up from 0.31% on July 18, 2022, according to Federal Deposit Insurance Corporation (FDIC) data. That said, many CDs offer rates in excess of 5%. Here are some of the best available rates today.

For further context on ways investors can find a CD that works for their investment profile, Marianela Collado, a certified financial planner with Tobias Financial, says that it’s best to look at the rate being offered and the time you are locking in the funds.

“You have to think about where rates can go in the future,” she says, adding that “if you expect that rates will go up again, that means that new CDs will be paying a higher rate so you have to think about how long you want to lock yourself into a CD.”  She adds, however, that the opposite can be true if you think that the Fed will lower rates.  

Certificate of deposit terms 

When choosing a CD, consider your personal savings timeline and goals, says Cho. “Are you saving for a short-term goal like a Caribbean vacation or are you saving for the long haul, like a down payment on your dream home?”

That’s why understanding the length of a CD, or the term, is one of the most critical parts of selecting the one that is right for an individual’s financial needs. CD terms tend to range from about three months to five years or more.  So if you have a goal of going on a vacation in one year, you might opt for a CD with a one-year term, for example — assuming you can get a good rate on it.

When looking through a given CD’s promotional page on a bank or credit union website, there is often a tab for rates and how those rates vary depending on the available terms. Generally speaking, the longer the term, the better the rate. However promotional rates for a shorter term CD, say one ending in 9 months for example, can sometimes offer the best rate in order to attract new customers. 

For example, a one-month CD, on average, has a 0.20% APY, while 3-month terms are an average of 1.07%, according to the FDIC as of July 17. (You can see some of the best CD rates here.)

After reaching the maturity date, account holders also have the option to extend the term or roll their earned interest into a new CD. “Or maybe you want to take the money from your CD and place it into equities, a HYSA, or another type of investment,” suggests Cho. “At the end of the day, that’s entirely up to you.”

CD penalties

CDs typically come with early withdrawal penalties. Avoiding these fees, though, is pretty simple: just stick with the CD until the end of the previously specified maturity date. These fees often charge a certain percentage of earned interest. For example, Investopedia offers these hypothetical scenarios: 

• CDs that have a maturity date of six months or more may charge the equivalent of three months’ interest for taking your money out prior to that six-month date.
• Longer-term CDs, however, may charge as much as 12-months interest or more.

To avoid these penalties, investors should first be sure to determine just how long you can keep your money locked away, says Cho. “Typically, fixed-rate CDs are stricter when it comes to early withdrawals,” Cho says, adding however, that so-called no penalty CDs, on the other hand, offer you a bit more flexibility should you need to access your cash early. “If you require even more flexibility and immediate liquidity, CDs in general may not be the right choice for you, and you might want to consider a vehicle such as a high-yield savings account instead.”

Types of certificates of deposit

As previously alluded to in this article, there are dozens of versions of CDs and subsequent rules sets. Here are 12 of the most common types of CDs Bankrate says you can find on the market today: 

Traditional CD

Meet the minimum deposit requirement and stick with this CD for the predetermined set of time and you stand to earn a promised interest rate on your investment. Likely the biggest risk here is that you will be charged interest and/or principal for withdrawing your money prior to the predetermined maturity date. 

Bump-up CD

Much like a traditional CD, this version includes a clause that allows clients to ride the interest-rate wave by making a one-time increase to the originally agreed upon rate in the original terms. One downside here is the bump-up CD often has a lower starting rate than a traditional CD; therefore you will ultimately be later “bumping up” to a more competitive interest rate. 

Step-up CD

Similar to its counterparts, the traditional and bump-up CD, the step-up version also locks in your money for the duration of the previously determined maturity date, otherwise its clients can incur an early withdrawal penalty.

The key difference here, though, is that the interest rate can theoretically increase along with rising interest rates and you don’t have to request the increase like you would with a bump-up CD. Some downsides are that the rates are often not as competitive as traditional CDs, and the increased rate is often a blended APY with the current term and increased rate. Therefore, if you started with a 0.05% rate and it increases to 0.65%, you may only “step up” to a blended 0.35% rate, according to one example on Investopedia. 

Add-on CD

Although most CDs only allow individuals to make a single deposit, the add-on CD allows additional deposits throughout its maturity.

No-penalty CD

Like the name suggests, no-penalty CDs have one key difference from all three of the previously mentioned versions: there is no early withdrawal penalty for taking out your money before the maturity date. These rates are often lower than the traditional CD; however many choose this option to have more liquidity with their investable assets. 

Zero-coupon CD

These CDs do not pay any interest at all. Instead, investors in this CD have the opportunity to purchase at a steep discount and receive a guaranteed amount of increased principal at the end of the maturity period.

One consideration to make here is these terms are typically longer than a traditional CD, so you will have to wait some time before realizing your gains.

Another drawback is that account holders have to declare accruing interest on the CD each year and pay taxes rather than paying the taxes in full at the end of the term. This usually results in a larger tax bill. 

Callable CD

Much like a fixed-income security, these CDs come with a call feature, allowing the issuing bank to redeem the principal prior to the previously stated maturity date. Banks often make the decision to end a callable CD early when the interest rate agreed to at the time of purchase decreases.

If a CD is called back, the bank would then return your principal plus the earned interest at that period. If you wanted to stay with that particular issuer, you would have to purchase a new CD at the current rate. 

Brokered CD

Simply put, a brokered CD is a CD that is purchased through a broker or brokerage firm, or through a sales representative at a bank, rather than directly through a bank or credit union. These CDs can also be traded like bonds so they are in effect a more liquid option than a traditional option. 

High-yield CD

Similar to a high-yield savings account, high-yield CDs are offered by banks or credit unions actively engaging in competition with one another to offer the highest possible rate for a CD. 

Jumbo CD

If you have a large sum of money to invest in a CD, say more than $100,000, then a jumbo CD might be what you’re looking for. These CDs often come with higher rates and also offer longer maturity periods. Read here for more. 

IRA CD

This type of CD is simply one of many ways an individual’s IRA assets can be invested. While IRA CDs can indeed earn a fixed interest rate, some financial institutions may even offer a variable rate on these products. 

Foreign currency CD

If you’re interested in earning interest on a currency other than the U.S. dollar, then a foreign currency CD might be what you’re looking for. These can be purchased at a U.S. financial institution that offers foreign currency accounts or at a bank that offers international investments. 

How to open a certificate of deposit

Getting started is a fairly simple process. Just find the CD that works with your financial goals and limitations at any number of bank or credit union websites, and apply. 

That said, there are often membership requirements for CDs, also known as share certificates, at credit unions. Be sure to read all of the fine print to know if you qualify, or consult with a financial adviser or professional for assistance. Some CDs on the other hand, such as brokered CDs, require that you work directly with a broker or financial institution to open an account. (You can see some of the best CD rates here.)

How to choose a certificate of deposit and how do you find the best CD rates?

After you’ve decided which CD is best for your financial plan, seeking out the best possible offer is likely your next challenge. Depending on the financial institution and term you choose, interest rates can fluctuate significantly.

That is partially because the real rate of return earned on a CD, or APY, often correlates with the terms, with longer CD terms typically earning higher rates. These terms can also range with banks and credit unions offering products such as a 3-month CD, 1-year, 2-year CD, 5-year CD, or even longer (or shorter) in some cases.

Start with a simple Google search for the best available rates; it doesn’t take long to find dozens of news outlets, financial institutions and research firms with “best of” rankings for the highest interest rates and best offers. That said, knowing which bank or credit union’s offer that you are qualified for, in many cases, can be a deal breaker or maker. 

Take a recent ranking from MarketWatch Picks for example: reading through this story can indeed help you find banks and credit unions with the best rates, however it will take some of your own research to know if those offerings also fit with your needs. When you’re looking into a bank or credit union’s CD lineup, one helpful feature many offer is an interest rate tier. These usually show the terms, minimum balance requirements, dividend rate and APY for each of the available offerings. 

Balance requirements can range anywhere from $0 to $100,000 or more to earn the promoted interest rates, depending on the product; as well as restrictions such as where you live or even what you do for a living. These can all determine whether you can open an account at a given provider and earn that flashy APY. 

CDs vs. money market accounts

If earning high APY is what you’re after, consider other savings account options. One such option is a money market account, sometimes referred to as money market deposit account (MMDA), which is also a high-earning deposit account offered by banks and credit unions.

While you may not earn as high of a rate as a CD, these accounts can come pretty close. There is also more liquidity than a certificate of deposit and your money will not be locked away for a set period of time in order to earn interest.

Money market accounts also frequently offer debit cards and the ability to write a limited number of checks per month to make penalty-free withdrawals. Restrictions here include the ability to write a limited number of checks and make a certain number debit card transactions per month.

Learn about CDs vs. bonds here, and how to open a certificate of deposit here.

CDs vs. savings accounts

Also unlike a CD, traditional savings accounts and high-yield savings accounts do not come with term limits to earn interest. You won’t be penalized for taking your money out, however savings accounts do not typically come with debit cards or checks to make easy withdrawals the way, say, a money market account would. In most cases, you will have a routing number to make transactions.

And although you may not earn as high of an interest rate, there are plenty of options out there today that are closely aligned with the APY available with some of the highest earning CDs on the market today. If you’re looking for a high-yield savings account with the best rate, here are 10 of the highest offers though July 2023. See some of the best savings account rates you may get now here.

How safe are certificates of deposit?

CDs are one of the safest ways you can invest your cash. That said, your money is only as safe as the financial institution you choose to work with.

That’s why it’s important to ensure any bank offering a CD you are interested in opening is insured by the FDIC, which protects depositors by up to $250,000, or $500,000 for joint account holders. The National Credit Union Administration, or NCUA, meanwhile, insured depositors with money held in a credit union by up to $250,000. 

“As you build out your investment portfolio, I would keep this insured limit in mind when depositing your funds,” says Cho.

How much should I invest in certificates of deposit?

There’s no right amount or exact rule of thumb for CD investing, Cho says. “It all comes down to what your individual goals are, and how CDs can play a part in helping you accomplish them,” he says. “When I’m assisting my clients in this process, some enjoy the structure and stability of CDs, so their savings portfolios are built around CDs with various durations – known as laddering.” (Read more on how CD laddering works here.)

Other clients, Cho adds, prefer more diversity in their portfolios, so they maintain a mix of CDs, liquid money market holdings, and other asset classes for their portfolios. “I strongly encourage anyone interested in CDs to assess their personal financial goals and risk appetite, and then build their investment portfolio accordingly,” he says.

Collado says it all comes down to risk and the amount an investor is willing to comfortably take on while still maintaining a healthy cushion. “For folks with a higher tolerance for risk, they should carve out some portion of their liquid cash to earmark towards emergency savings and that will generally be anywhere between three months to 12 months of their living expenses,” she says. “Again, all based on risk tolerance. CDs could be a great tool to ladder emergency funds to mature based on that three- to- 12-month plan. (You can see some of the best CD rates here.)