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How does a certificate of deposit (CD) work? A 2024 primer

CDs are tools you can use to save money and earn a higher interest rate. Learn how CDs work and how to use them to boost your savings.

Yahoo Personal Finance· Getty Images
Updated 16 min read

It’s a new year, and if you have goals for self-improvement, a great place to start is with your wallet. If you’re like many Americans, you likely sock money away in your savings account, but did you know that the average annual percentage yield is just 0.35%? There are smarter ways to save and see much better returns: with a CD (certificate of deposit).

A CD is a low-risk type of savings account that helps you earn compound interest, while also locking in a higher yield for a period of time (unlike a high-yield savings account, which doesn’t promise a locked-in interest rate). With a CD, you deposit your money in the account and commit to leaving it there for a specific period of time, known as a fixed term. Basically, you’re trading the liquidity of your funds to earn a higher annual percentage yield (APY).

Before choosing a CD, it’s important to learn about how they work and to understand the pros and cons for each. Doing so will help you choose the account that’s best for you and your 2024 financial goals. So, how do CDs work?

You open a traditional CD by depositing a lump sum with a bank or credit union. (Note: At credit unions, CDs are known as share certificates.) The funds you deposit earn a fixed percentage of interest for a predetermined period of time.

Depending on the terms of your account, the bank or credit union may deposit the interest you earn back into your CD or pay those earnings out to you at regular intervals (e.g., once a month or once a year). Yet unlike standard savings accounts, you must typically agree not to withdraw any funds from your CD until it reaches maturity. At that point, you can withdraw the funds or roll them into a new CD.

The average savings account has an APY of 0.47% as of March 18, 2024, according to the Federal Deposit Insurance Corporation (FDIC). Average rates for 1-year CDs, by comparison, are 1.81%. And some of the best CD rates are over three times higher than the national average. Therefore, it’s essential to shop around for the best CD rates to maximize the earning potential on your savings.

Regardless of the interest rate you lock in, if you try to withdraw your cash before a CD reaches maturity, you could face an early withdrawal penalty. These penalties can cut into or wipe out the interest you earn on your savings, so it’s important to plan ahead and only deposit as much money into CDs as you feel comfortable leaving untouched for a predetermined period.

A CD is a type of deposit account you can open with most banks and credit unions. It provides a safe place to deposit money and earn interest over time. A CD offers a guaranteed return when you keep your money in the account for a set period of time as the interest rate stays the same for the entire term.

The appeal of a CD is it typically provides a higher annual percentage yield, or APY, than a traditional savings account. A CD pays a higher interest rate because you commit to leaving your money in the account for a specific period. For example, you may invest your money for six, 12, or 60 months.

While your money is in the account, the bank or credit union pays you interest, and that interest compounds — you earn interest on the money you deposit plus the interest your money earns. When the CD reaches its end date, you receive the original amount you invested plus the interest that accrued.

The downside of CDs is that they provide less liquidity. If you withdraw money from the CD before its maturity date, you will likely pay an early withdrawal penalty and potentially give up some of the earned interest.

Read more: How to calculate interest on a CD

Of course, like any other type of bank account or savings vehicle, CDs have their pros and cons. They aren’t right for everyone, but they can certainly be a smart move at the right time for others. Below is a quick summary of those benefits and drawbacks, but you can also learn more about the pros and cons of CDs in depth.

  • Unlike the stock market, CDs offer guaranteed returns making them a low-risk way to grow your savings.

  • CDs offer higher returns on average compared with other deposit accounts.

  • When you open CDs from federally insured banks or credit unions, your deposits are insured for up to $250,000 (per financial institution).

  • Opening CDs may discourage the temptation to tap into your savings early since unplanned withdrawals usually result in a penalty.

  • If you need to access your cash before a CD’s maturity date, you’ll typically have to pay an early withdrawal penalty to do so.

  • The interest rates on CDs — especially long-term CDs — might struggle to keep up with rising inflation over time.

  • Although CDs are a safer savings option, they feature lower historical returns compared with higher-risk investments (by comparison) like mutual funds and stocks.

The most common type of CD pays a fixed interest rate for a certain time. But there are other types of CDs:

  • Brokered CDs: CDs are usually purchased through banks or credit unions. But you also can buy CDs from brokerage firms. Brokered CDs can sometimes provide higher APYs than other CDs, but be careful — deposit brokers aren’t licensed or certified, so look up the broker’s information on the US Securities and Exchange Commission (SEC) database to ensure the broker is reputable before handing over your money.

  • Step-up CDs: With a step-up CD, the interest rate will increase over the CD’s term. For example, the interest rate may increase once per year, and you know the rate every year of the term in advance.

  • No-penalty CDs: No-penalty CDs allow you to make early withdrawals without paying penalties, but they usually have lower APYs than other CDs.

  • Callable CDs: A callable CD often provides a higher APY than other CDs. However, they have a call feature, meaning the issuer can end the CD before its maturity date. An issuer would usually do this if interest rates drop and it wants to avoid paying the higher interest rate. The issuer can call the CD as early as six months after its purchase date.

  • Variable-rate CDs: When you open a variable-rate CD, the interest rate can fluctuate up and down with the market rather than remain fixed until your maturity date arrives. If interest rates increase, you could earn more on your savings with a variable-rate CD. But there’s a risk your APY could drop if rates decline.

  • Zero coupon CDs: With zero coupon CDs, the financial institution that issues the account doesn’t pay you interest during its term. Rather, you purchase the CD at a discount. When the CD matures at the end of its term, the bank pays you its full face value. For example, you might pay $4,000 for a five-year zero coupon CD with a face value of $5,000. That arrangement would equal an APY of 5% — $200 in interest each year for five years.

  • Bull CDs: The interest you earn on bull CDs is tied to a specific market index. When (and if) that market index rises, a bull CD will pay you a predetermined percentage in the form of interest as a return on your investment. Most bull CDs also feature a guaranteed minimum rate of return.

  • Bear CDs: Bear CDs are also tied to a specific market index, but the potential returns you may earn from a bear CD are based on shares of any market declines that occur. If the index decreases, the CD’s interest rate climbs, and the opposite is true as well.

  • Jumbo CDs: Jumbo CDs are for individuals with large sums of cash to save. For example, the minimum investment might be $100,000 or more. In exchange, the issuer pays a higher APY.

  • Bump-up CDs: With a bump-up CD, you can request an increase in your annual percentage yield (APY) if interest rates rise at your financial institution before your CD matures. In general, you can only request one rate increase per term with a bump-up CD, but some banks may allow for multiple requests for long-term CDs. The initial APYs on bump-up CDs are often lower compared to other types of CDs as well.

  • Uninsured CDs: Uninsured CDs are not covered by the FDIC or the National Credit Union Administration (NCUA). Because you are assuming more risk when you open these types of deposit accounts, uninsured CDs might feature higher APYs compared with traditional certificates of deposit.

Click the image to learn more about CDs

Whether you’re saving for a down payment, home improvements, or another short- to mid-term financial goal, when you invest in a CD you might reach your objective faster. Yet because CDs lock away your money for a period of time, using them requires more planning than storing your cash in more liquid savings accounts.

Below are three common CD savings strategies to consider.

CD laddering is a savings strategy that involves opening multiple CDs with staggered maturity dates. By spacing out the dates at which your CDs mature, the goal is to maintain access to a portion of your savings at periodic intervals while still earning higher interest rates than you would in a more liquid type of deposit account.

Here’s an example of a CD ladder. Imagine you open three certificates of deposit — a 6-month CD, a 12-month CD, and an 18-month CD — and you split your savings into even amounts among each account. This setup would allow you to access or roll over the cash in your CDs at six-month intervals.

When the first CD in your ladder matures, you could open a new 2-year CD with that chunk of your savings (assuming you don’t need to use the money for another purpose). Opening a new CD would continue the cycle — permitting you access to a portion of your savings every six months while also enjoying the higher interest rates that CDs have to offer.

A CD barbell is another financial tactic that involves dividing your savings between multiple CDs with different maturity dates. However, with this approach, you choose long-term and short-term accounts with no medium-term CD options.

The idea of the barbell strategy is to maintain access to a portion of your cash savings by investing some of your funds in short-term CDs. With the remainder of your savings, however, the goal is to earn the highest interest rates possible (which may be available with long-term CDs).

Yet there are two potential flaws with this savings strategy. First, long-term CDs don’t always offer the highest APYs available. And if you lock in a rate on a long-term CD in an environment where rates are on the rise (as they have been in recent months), you might miss out on the opportunity to earn higher APYs in the future.

The CD bullet approach can be worth considering if you’re saving toward a big financial goal. This savings method involves opening several CDs with similar maturity dates. The goal is to have the money from multiple certificates of deposit become available around the same time.

Here’s how the bullet CD strategy works. Imagine you’re saving money for a down payment on a house that you plan to purchase in five years. To start the savings process, you deposit a lump sum into a five-year CD. The following year, you have more cash available, so you decide to open a four-year CD, which will mature around the same time as the original account you opened.

You repeat the process each year with additional lump sum deposits into new CDs (e.g., a three-year CD, a two-year CD, a one-year CD, etc.). After your CDs mature, you apply all the funds toward your financial objective including, of course, any interest your cash earns along the way.

CD rates and terms vary by bank or credit union, so shopping around is wise. When comparing CDs, consider the following factors:

Banks and credit unions control their rates, so you’ll find that CD rates can vary widely between financial institutions. Institutions that are trying to attract deposits — which can be turned around as mortgages and auto loans — will offer higher rates than those who have plenty of cash on hand to lend. Your corner bank might offer 1% APY, while you may see deals online for several times that.

When comparing APYs, find out whether the CD has a fixed or variable APY. While fixed-rate CDs are the most common, some have a variable rate, meaning they will change over time. A variable-rate CD may be appealing because it has the best cd ratesof its higher initial rate, but it could decrease later.

The time frame for a CD can be as short as a month or as long as 25 years. With most CDs, your money is locked up in the CD until its maturity date, so you cannot access your funds without paying penalties. Generally — though, not always — longer terms give you a higher APY because you sacrifice liquidity.

With a traditional CD, you pay a penalty if you withdraw money before its maturity date. Generally, you forfeit some of the interest that accrued. Depending on the CD’s term length and how early you take out money, you could lose between three to 24 months of simple interest. In some cases, the penalty can eat into your initial deposit.

CD minimum deposits vary by bank or credit union and typically range from $500 to $5,000.

Although a CD can be a good option to grow your money, it may not be the best choice for all your financial decisions. To make your money work harder, consider the following alternative financial products:

  1. High-yield savings accounts (HYSAs): With an HYSA, you can earn a higher APY than a traditional savings account. High-yield savings accounts don’t have the restrictions on withdrawals that CDs do, so you can access your cash without penalties.

  2. Money market accounts: Money market accounts are a type of deposit account that offer flexible access to your funds similar to a checking account, coupled with a higher interest rate than what you might get with a traditional savings account.

  3. Series I Bonds: For those looking for safe investment options, I bonds issued by the US Department of the Treasury can be a smart alternative. Series I bonds pay a fixed rate of interest plus a rate of interest that adjusts with inflation. While CD rates stay the same for the CD’s term, I bonds can increase as inflation rises, providing you with some protection. Series I bonds issued between November 1, 2022, and April 30, 2023, have a rate of 6.89%.

  4. Index funds: If you’re looking for higher returns, investing in index funds may make more sense than investing in CDs. Although index fund prices can fluctuate, historically, they provide higher returns than CDs. For example, the S&P 500 — which tracks the performance of 500 of the country’s top companies — has an annualized 10-year return of 9.64%.

Read more:

If you still have questions about CDs, check out these answers to commonly-asked questions:

When a CD reaches its maturity date, you can either withdraw your money or renew the CD. If you opt for a renewal, you deposit the money into another CD at the same bank with a new term and interest rate. Depending on the bank or credit union the CD is with, you may have a grace period to decide whether to renew it.

Yes, like other deposit accounts, your CD bank account funds are typically federally insured, either through the FDIC or the NCUA. FDIC-insured and NCUA-insured funds are covered up to $250,000.

You may be weighing CDs vs. savings accounts. With some effort, you can find outstanding rates for both. But which account is best for you is dependent on your goals.

A savings account makes sense for the money you may need in the near future, such as in the next six to 18 months. Because there aren’t penalties for taking money out of your savings account, they’re a good fit for your emergency fund and other short-term savings goals.

A high-yield CD allows you to earn a higher interest rate than savings accounts but is less liquid, so they’re best for longer-term financial goals or a big purchase, such as putting a down payment on a house or buying a car. Only put money into a CD that you won’t need to cover routine or emergency expenses. Otherwise, you’ll have to pay withdrawal penalties.

Whether it’s better to invest in CDs or stocks depends on your age, goals, and risk tolerance.

If you’re young with decades until your target retirement date, investing in the stock market is likely the best choice. You can take advantage of market increases and compounding, so your money will have more potential for growth. And because of your age, you have more time to recover from market fluctuations.

A CD is a safer investment than the stock market if you’re older — or if your goals have a shorter time horizon, such as one to five years. You’ll likely earn a lower return, but you don’t have the risk of losing your money like you would with stocks.

Not sure which is best for you? Meet with a financial advisor for personalized advice. You can use the National Association of Personal Finance Advisors’ locator tool to find one near you.

In general, CDs only permit a fixed amount of cash. Once you’ve opened a CD, you cannot add money to the account.

However, you can use any additional funds to open another CD. You can open another CD with the same bank or shop around with other banks and credit unions to find the best rates.

Michelle Lambright Black contributed to this article.