What a Certificate of Deposit Does

A certificate of deposit (CD) is an agreement between you and a bank or credit union: you give them a sum of money for a fixed period of time, and they pay you a set interest rate on that money. You cannot withdraw the money before the time ends without paying a penalty. The bank uses your money during that period and pays you back the full amount plus interest when the term is over.

The trade-off is straightforward. In exchange for leaving your money untouched, you get a higher interest rate than a regular savings account offers. The longer you agree to lock the money away, the higher the rate usually is. If you need the money before the term ends, you lose some or all of the interest you would have earned, and sometimes part of your principal.

Key Takeaways

  • You deposit a lump sum, agree to leave it for a set term (three months to five years or longer), and receive a fixed interest rate for that entire period.
  • The bank pays you all your money back plus the interest earned when the term ends, unless you withdraw early and trigger a penalty.
  • Early withdrawal penalties vary by bank and by term length; a shorter-term CD usually has a smaller penalty than a longer one.
  • Your CD is insured by the FDIC (at banks) or NCUA (at credit unions) up to $250,000, so your principal is protected even if the institution fails.
  • Interest rates on CDs change based on what the Federal Reserve does with its benchmark rate, so rates available today will not be the same next month.

How the Term and Interest Rate Work Together

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 one month or as long as ten years. The interest rate is set when you open the CD and stays the same for the entire term—it does not change if market rates go up or down.

Longer terms almost always come with higher rates. A one-year CD might pay 4.5 percent, while a five-year CD from the same bank might pay 5.2 percent. The bank is willing to pay more because it knows it will have your money for longer and can lend it out or invest it for a longer period. Shorter terms pay less because the bank has less time to use your money.

The interest accrues (builds up) during the term. Some CDs pay interest monthly, some quarterly, and some only at the end. The way interest is calculated and paid does not change the total amount you receive at maturity—the end date of the CD.

What Happens at Maturity and After

When your CD term ends, the bank sends you a notice a few weeks before the maturity date. At that point, you have choices. You can withdraw the full amount (principal plus all interest earned) with no penalty. You can let the CD automatically renew for another term at whatever rate the bank is offering at that time. Or you can move the money to a different CD, a savings account, or somewhere else entirely.

If you do nothing and the bank's policy allows automatic renewal, your CD will roll into a new term at the new rate. That new rate might be higher or lower than what you earned before. Read the renewal terms carefully, because you usually have a grace period (often seven to ten days) after maturity to withdraw your money without penalty if you change your mind about renewing.

Early Withdrawal Penalties and How They Work

If you need your money before the term ends, the bank will let you take it—but you will pay a penalty. The penalty is usually expressed as a number of months of interest. A CD with a six-month interest penalty means you lose six months' worth of the interest you would have earned. On a $10,000 CD earning 5 percent annually, that would be about $250.

Penalties vary widely. A three-month CD might have a one-month penalty. A five-year CD might have a six-month or even one-year penalty. Some banks charge a flat dollar amount instead of months of interest. Before you open a CD, ask the bank what the early withdrawal penalty is—it should be in the disclosure document they give you, but it is worth confirming.

The penalty comes out of your interest first. If you have earned enough interest to cover it, you lose only the interest. If you have not earned that much yet, the penalty eats into your principal, and you get back less than you deposited. This is why early withdrawal is costly and why CDs work best for money you truly will not need.

How Interest Rates Are Set and Why They Change

CD rates are set by each bank individually, but they all respond to the same force: the Federal Reserve's benchmark interest rate. When the Fed raises its rate, banks raise CD rates to attract deposits. When the Fed lowers its rate, CD rates fall. The rate you see today will not be the rate available next week or next month.

This matters if you are deciding between opening a CD now or waiting. If you think rates will go up, waiting might get you a better rate. If you think rates will fall, locking in a rate now protects you. But no one can predict the Fed's moves with certainty. Many people split the difference by opening a CD ladder—multiple CDs with different term lengths so that some mature and can be renewed at higher rates if rates have risen.

FDIC and NCUA Insurance Protection

Your CD is protected by deposit insurance. If you open a CD at a bank, the Federal Deposit Insurance Corporation (FDIC) insures it up to $250,000. If you open a CD at a credit union, the National Credit Union Administration (NCUA) insures it up to $250,000. This protection covers your principal and all accrued interest.

The insurance applies per depositor, per institution. If you have $150,000 in a CD at Bank A and $150,000 in a CD at Bank B, both are fully covered. If you have $300,000 in a CD at the same bank, only $250,000 is covered. Joint account CDs are insured separately, so a couple with a joint CD is covered up to $250,000 each. This insurance means your money is safe even if the bank or credit union fails.

CD Ladders and Other Strategies

A CD ladder is a way to balance the higher rates of longer terms with the flexibility of shorter ones. Instead of putting all your money in one five-year CD, you might open five one-year CDs with the same amount in each. Every year, one CD matures, and you can either withdraw the money or open a new one-year CD at the current rate. This way, you always have access to some of your money and always have the chance to lock in a new rate.

Another approach is a CD bump-up or raise-your-rate CD, offered by some banks. This CD lets you request one rate increase during the term if rates go up. It pays a slightly lower starting rate than a standard CD, but it gives you a chance to benefit if the Fed raises rates while your CD is open. The terms of bump-up CDs vary by bank, so read the details before opening one.

Frequently Asked Questions

Can I withdraw money from a CD before it matures?

Yes, but you will pay an early withdrawal penalty set by your bank. The penalty is usually a certain number of months of interest. If the penalty is larger than the interest you have earned so far, the penalty will reduce your principal. Check your bank's disclosure document to see the exact penalty before you open the CD.

What is the difference between a CD and a savings account?

A savings account has no term and no penalty for withdrawal, but it pays a much lower interest rate. A CD locks your money for a set period and pays a higher rate in exchange. If you need flexibility, use a savings account. If you have money you will not need for a known period, a CD pays more.

Do I have to pay taxes on CD interest?

Yes. CD interest is taxable income in the year it is earned or credited to your account, depending on how your bank handles it. The bank will send you a 1099-INT form at tax time showing how much interest you earned. This is true even if you did not withdraw the money yet.

What happens if I do not withdraw my money when the CD matures?

Most banks automatically renew your CD for another term at the new rate they are offering. You usually have a grace period of seven to ten days after maturity to withdraw without penalty if you change your mind. Check your renewal notice to see your bank's exact policy and the new rate.

Is my CD safe if the bank goes out of business?

Yes. The FDIC (for banks) or NCUA (for credit unions) insures CDs up to $250,000 per depositor per institution. Your principal and all accrued interest are covered by this insurance, so your money is protected even if the institution fails.