Certificates of Deposit (CDs) Explained: How They Work and When to Use Them

A certificate of deposit, or CD, is a savings account that holds your money for a fixed period in exchange for a set interest rate. It is one of the simplest and safest ways to earn interest on cash you don’t need right away, and it can be a useful tool for specific savings goals.

How CDs work

When you open a CD, you deposit a lump sum for a set term. Common terms range from three months to five years, and some banks offer even shorter or longer options. The bank agrees to pay you a fixed interest rate for that entire term. In return, you agree to leave the money untouched until the CD matures.

When the term ends, the CD has reached maturity. At that point you can withdraw your original deposit plus the interest you earned, move the money elsewhere or renew the CD for another term.

Generally, longer terms pay higher rates than shorter ones, because you are committing your money for longer. That isn’t always the case, however. When interest rates are expected to fall, banks sometimes pay similar or even higher rates on shorter CDs. Comparing rates across terms is always worthwhile.

Early withdrawal penalties

The trade-off for a guaranteed rate is reduced flexibility. If you take money out before the term ends, you will usually pay an early withdrawal penalty, typically a certain number of months’ worth of interest. On a short-term CD or one you break very early, the penalty can even eat into your original deposit.

Some banks offer no-penalty CDs, sometimes called liquid CDs, which let you withdraw without a penalty after a short initial period. These usually pay a lower rate than standard CDs, but they can be a good middle ground if you want a fixed rate with an escape hatch.

The pros of CDs

CDs offer predictable, fixed returns. You know exactly how much interest you will earn from the day you open the account, which makes them helpful for planning. Their rates are often higher than those of regular savings accounts, particularly at online banks and credit unions.

They are also very safe. CDs at FDIC-insured banks or NCUA-insured credit unions are protected up to $250,000 per depositor, per insured institution, for each account ownership category. Your money and earned interest are covered up to that limit even if the institution fails.

Finally, the commitment can be a benefit in itself. Locking money away makes it harder to dip into savings meant for a specific purpose.

The cons of CDs

Your money is locked up, so a CD is a poor choice for funds you might need on short notice. If interest rates rise after you open a CD, you are stuck with your lower rate until maturity. And over long periods, the returns on CDs may not keep pace with inflation, which means your purchasing power could slowly shrink. For long-term goals like retirement, investments such as diversified stock and bond funds have historically offered higher returns, though with more risk.

Building a CD ladder

A CD ladder is a strategy that balances access with higher rates. Instead of putting all your money into one CD, you divide it across several CDs with staggered maturity dates, such as one, two, three, four and five years.

As each CD matures, you can either use the money or reinvest it in a new long-term CD at the top of the ladder. Over time, you end up with a CD maturing every year, giving you regular access to cash while most of your money earns longer-term rates. A ladder also reduces the risk of locking everything in at a low rate right before rates rise.

Other types of CDs

Beyond standard and no-penalty CDs, you may encounter bump-up CDs, which let you request a higher rate once during the term if the bank’s rates rise, and jumbo CDs, which require a large minimum deposit and sometimes pay slightly more. Brokered CDs are sold through brokerage accounts and can sometimes be sold before maturity on a secondary market, though their value may change with interest rates.

When CDs make sense

CDs work well for money you won’t need for a known period, such as a down payment you plan to make in two years, a wedding next year or a planned car purchase. Matching the CD term to your goal date lets you earn a guaranteed rate without worrying about market swings.

For an emergency fund, keep at least a portion in a regular high-yield savings account you can reach anytime. Some people keep a few months of expenses in savings and place additional reserves in a short CD ladder for a slightly higher return.

How to choose a CD

Compare rates across banks and credit unions, including online institutions. Check the minimum deposit, the early withdrawal penalty, what happens at maturity and confirm that the institution is federally insured. A few minutes of comparison can noticeably improve your return.