A Certificate of Deposit Is a Savings Account With a Fixed Term and a Locked Interest Rate

A certificate of deposit, or CD, is a savings product where you give a bank or credit union a sum of money for a set period of time — called the term — in exchange for a may provide interest rate. You cannot withdraw the money before the term ends without paying a penalty. In return for leaving your money untouched, the bank pays you more interest than it would on a regular savings account.

The bank knows exactly how long it will hold your money, so it can lend that money out with confidence. That certainty is why it pays you more. A regular savings account lets you withdraw whenever you want, so the bank cannot count on having your money available — and pays less interest because of that risk.

CDs are offered by banks, credit unions, and some online financial institutions. The Federal Deposit Insurance Corporation (FDIC) insures CDs at banks up to $250,000 per depositor per institution, and the National Credit Union Administration (NCUA) insures CDs at credit unions up to the same amount. That insurance means your money is protected even if the institution fails.

Key Takeaways

  • You deposit money into a CD for a fixed term — typically three months to five years — and cannot withdraw it early without paying a penalty.
  • The interest rate is locked in when you open the CD and does not change, even if market rates rise or fall during your term.
  • CDs pay more interest than savings accounts because the bank knows your money will stay put for the entire term.
  • Your deposit is insured up to $250,000 by the FDIC (at banks) or NCUA (at credit unions), so your principal is protected.
  • When your term ends, you can withdraw your money and interest, open a new CD, or let the money roll over into another CD at the bank's current rate.

How the Term and Interest Rate Work Together

When you open a CD, you choose a term length. Common terms are three months, six months, one year, two years, three years, and five years. The longer the term, the higher the interest rate the bank usually offers — because you are committing your money for a longer period and the bank has more certainty about how long it can use those funds.

The interest rate is fixed, meaning it stays the same for the entire term. If you open a one-year CD at 4.5 percent interest, you will earn 4.5 percent for the full year, regardless of whether market interest rates go up or down. That predictability is one reason people choose CDs: you know exactly how much you will have when the term ends.

Interest on a CD is usually compounded daily or monthly, depending on the bank's terms. Compounding means the bank pays interest on your interest, so your balance grows a little faster than straightforward interest would. The bank will tell you how often interest compounds when you open the account.

What Happens If You Withdraw Money Early

If you need your money before the term ends, you can withdraw it — but the bank will charge you an early withdrawal penalty. The penalty amount varies by bank and by term length. A three-month CD might have a penalty equal to one month of interest, while a five-year CD might have a penalty equal to six months of interest or more.

The penalty comes out of your balance. If you withdraw $5,000 from a CD early and the penalty is $50, you receive $4,950. In some cases, if you have not earned enough interest yet, the penalty can eat into your original deposit, meaning you get back less than you put in.

Before you open a CD, read the disclosure document to find out what the early withdrawal penalty is. Some banks offer "no-penalty CDs" that let you withdraw without a penalty, but these typically pay lower interest rates than standard CDs.

When Your CD Term Ends

When your CD reaches its maturity date — the end of the term — you have options. You can withdraw the full amount (your original deposit plus all the interest you earned) and do something else with the money. You can open a new CD at the bank's current rates, which may be higher or lower than what you earned on the previous CD. Or you can let the money roll over into a new CD at the bank's current rate automatically.

Most banks have a grace period — usually seven to ten days — after maturity during which you can withdraw your money without penalty or decide what to do next. If you do nothing during that window and the bank's terms allow automatic rollover, your money will move into a new CD at whatever rate the bank is currently offering. Check your CD agreement to see whether your bank does automatic rollovers and what the grace period is.

CDs Compared to Savings Accounts and Money Market Accounts

A regular savings account has no term and no penalty for withdrawal. You can take your money out whenever you want. In exchange for that flexibility, savings accounts pay lower interest rates than CDs. If you might need the money within a year or two, a savings account is usually the better choice.

A money market account is a hybrid: it pays higher interest than a savings account (though usually less than a CD) and lets you write checks or make a limited number of withdrawals per month without penalty. Money market accounts are useful if you want some of the higher interest of a CD but need occasional access to your funds.

CDs make sense if you have money you will not need for a specific period and want to lock in a may provide rate. They are not the right choice if you might need the money sooner, because the early withdrawal penalty will cost you.

How Interest Rates on CDs Are Set

Banks set their own CD rates based on what the Federal Reserve does with short-term interest rates and what other banks in the area are offering. When the Federal Reserve raises its benchmark rate, banks typically raise CD rates over time. When the Fed lowers rates, CD rates usually fall.

Different banks offer different rates for the same term length. A large national bank might offer 4.0 percent on a one-year CD while an online bank offers 4.5 percent for the same term. Shopping around before you open a CD can mean earning significantly more interest over the life of the account.

The rate you see advertised is the annual percentage yield, or APY. This is the actual return you will earn in a year, including the effect of compounding. It is different from the interest rate itself, which does not account for compounding.

Who Should Consider a CD

CDs work well for people who have money sitting in a low-interest savings account and know they will not need it for a set period. If you are saving for a down payment on a house in three years, a three-year CD locks in a rate and keeps your principal safe. If you have an emergency fund that is fully funded and you have extra cash, a CD can earn more than a savings account.

CDs are also useful for people who worry about spending money if it is too straightforward to access. Because there is a penalty for early withdrawal, a CD creates a barrier that can help you stick to your savings goal.

CDs are not the right choice if you might need the money within the term, if you want to take advantage of rising interest rates by moving your money frequently, or if you are comfortable with the risk of investing in stocks or bonds for potentially higher returns.

Frequently Asked Questions

Can I open a CD with a very short term, like one month?

Some banks offer CDs with terms as short as one month, but most have a minimum of three months. Shorter-term CDs typically pay lower interest rates than longer terms. Check with your bank to see what the shortest available term is.

What happens to my CD if the bank fails?

Your CD is insured by the FDIC (if it is at a bank) or NCUA (if it is at a credit union) up to $250,000. If the institution fails, the insuring agency will return your principal and accrued interest up to that limit. You are protected even if the bank goes out of business.

Can I add more money to my CD after I open it?

No. Once you open a CD, you cannot add more money to that account. If you want to invest additional funds, you would need to open a separate CD. Some people open multiple CDs with staggered maturity dates so money becomes available at different times.

Is the interest I earn on a CD taxable?

Yes. Interest earned on a CD is taxable income in the year it is earned. Your bank will send you a Form 1099-INT at the end of the year showing how much interest you earned. You report this on your tax return.

What is a CD ladder?

A CD ladder is a strategy where you open multiple CDs with different term lengths — for example, one-year, two-year, and three-year CDs — so that one matures each year. This gives you regular access to portions of your money while keeping the rest locked in at higher rates.