How do CDs work?

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Certificates of deposit (CDs) are time deposit financial products that hold your funds for a set period. In exchange, you get fixed interest earnings, making CDs a reliable way to get a guaranteed rate of return.

Found at banks and credit unions, these safe investments often earn higher interest rates than traditional savings and money market accounts. However, CDs generally don’t offer as much liquidity. In fact, if you withdraw your money early from a CD, you’ll most likely pay a penalty to the bank or credit union.

If you’re curious about certificates of deposit and whether they’re a good option for you, here’s a close look at how CDs work.

How does a certificate of deposit work?

CDs work by offering a guaranteed return for keeping your money locked in the account for a set term. You can purchase these financial products from banks and credit unions, but they differ slightly in name.

For example, certificates of deposit are commonly known as “share certificates” at credit unions. Share certificates are very similar to CDs issued by banks. The only difference is that they are issued by a credit union.

Typically, the longer the CD term, the higher the interest rate. There are plenty of exceptions, however. When the CD reaches its maturity date, you can redeem it for your initial principal investment plus any interest earned.

With most CDs, if you try to withdraw money before the CD’s maturity date, you could get hit with a penalty that eats up all of your interest, and potentially, even some of your principal. Since CDs lack liquidity, the interest rates on CDs are commonly higher than rates on standard savings accounts. But that’s not always the case and the difference is not always dramatic. For example, currently the best nationally available 1-year CD is offering around 0.65 percent APY, while some of the best nationally available savings accounts currently offer around 0.55 percent APY.

Like savings accounts, CDs are inherently safe investments. They are insured up to $250,000 by the Federal Deposit Insurance Corporation at banks and by the National Credit Union Share Insurance Fund at National Credit Union Administration credit unions.

CD basics

These are the basic things you have to worry about when opening a CD.

CD rates

One of the first things to look at when you’re opening a CD is the annual percentage yield. The APY determines how much you’ll earn from the account. Higher APYs mean that you’ll earn more on your money.

Generally, the longer a CD’s term, the higher the APY will be; however, that’s not always the case and there are other factors that can influence rates. For example, online banks often pay higher yields than brick-and-mortar banks. Financial institutions can also offer promotional CDs with higher-than-usual APYs.

CD terms

The most common CD terms are three six, nine, 12, 18, 24, 36, 48 and 60 months. But it’s possible to find shorter and longer terms. Some banks and credit unions even issue CDs with unconventional terms, like seven, 13 or 17 months.

Savers could build a CD ladder, which involves buying multiple CDs at once that mature at different times.

CD maturity date

When the term of a CD ends, the CD is said to have matured. When the CD matures, you have the opportunity to make changes to it, such as withdrawing money from the account or renewing it.

For example, if you open a 12-month CD on January 1, 2021, its maturity date will be January 1, 2022. Most banks give you about a week from the maturity date to make changes to your account. If you don’t make any changes, the bank might roll your balance into a new CD with the same term as the previous CD.

The new CD will earn whatever APY the bank is offering for new accounts with that term, so it’s important to keep track of your CDs’ maturity dates. You don’t want to wind up being stuck with a low rate on a CD.

CD penalties

CDs are a time deposit account, meaning you’re making a commitment to keep your money in the CD for a set period of time. If you want to take money out of your CD before it matures, you’ll usually have to pay a penalty.

At many banks, the penalty is based on the amount of interest you earn in a day. Typically, CDs with longer terms will charge higher penalties.

For example, Bank of America charges:

  • The greater of all interest accrued or seven days’ interest for CDs on the amount withdrawn with a term shorter than 90 days
  • 90 days’ interest for CDs with terms ranging from 90 days to 12 months on the amount withdrawn
  • 180 days’ interest for CDs ranging with terms from 12 months to 60 months on the amount withdrawn
  • 365 days’ interest for CDs with terms greater than 60 months on the amount withdrawn

CD safety

One of the benefits of CDs is that they are a very safe way to store your money. Like other accounts offered by federally insured banks, they receive full protection from the Federal Deposit Insurance Corp.

The FDIC insures up to $250,000 per bank, per depositor. So long as your balance doesn’t rise above that amount, you won’t lose money if the bank closes or is otherwise unable to return your deposit.

The only way to lose money with a CD is by paying an early withdrawal fee that exceeds the amount of interest you’ve earned.

Types of CDs

There are a few different types of CDs that you can open. Here are some of the most popular.

Traditional CDs

Traditional CDs are the classic type of CD. You open the account, deposit money and wait until the CD matures. Then, you can then add more funds or withdraw them from the account.

Jumbo CDs

Jumbo CDs are like traditional CDs but they typically have much higher minimum deposit requirements, such as $100,000 or more. In exchange, they can offer higher interest rates.

No-penalty CDs

No-penalty CDs are more flexible than traditional CDs, waiving the penalty for early withdrawals. Typically, they pay less interest than traditional CDs.

Bump-up CDs

When you open a CD, you lock in your interest rate. So if you choose a long-term CD and rates rise, your money will be stuck at a lower rate. Bump-up CDs, however, usually start with a lower-than-typical interest rate, but give you the option to increase your account’s interest rate once or twice during the CD’s term.

IRA CDs

An IRA CD is an Individual Retirement Account that invests in CDs. You may want to consider getting an IRA if you are risk averse and want a guaranteed return on your retirement savings while also benefiting from tax advantages.

How to open a CD

Opening a CD, whether at a bank or credit union, generally involves choosing a type of CD, picking a term that meets your financial goals and then funding the CD.

Like any financial product, you will need to show the bank or credit union that you are who you say you are in order to open an account. You will generally need to have this information:

  • Your Social Security number (or Individual Taxpayer Identification Number)
  • A valid ID, such as a driver’s license
  • Your date of birth
  • A physical U.S. Address
  • A phone number
  • An email address
  • Money to deposit into the account

Then, you will fill out the application to open the product at the financial institution.

How much should I invest in a CD?

Just like when choosing a CD type and term, the amount of money you should park in a CD ultimately depends on your financial situation, goal and timeline.

It can help to connect the maturity of a CD to an event in your life to determine what’s best for you. For example, let’s say you want to purchase a $20,000 car in a year. Putting that money in a 12-month CD would earn you interest and keep you from touching your savings.

There are often minimum deposit requirements, however. Jumbo CDs, for example, often require deposits of $100,000 or more. Some banks, like Ally Bank, have no minimum deposit requirements for their CDs. Others, like Quontic Bank and Marcus by Goldman Sachs, offer CDs that only require $500 to open one.

Just be careful not to put all of your money in CDs. Inflation has historically risen over time, which reduces the purchasing power of money earning a yield below the rate of inflation.

Not sure if now is the right time to put your money in a CD? Learn more about your options today.

Can you lose money in a CD?

It is possible to lose money when you invest in a CD. The most obvious way that you could lose money is by withdrawing money before the term ends. If you do this, the financial institution may charge you an early withdrawal penalty with the interest you earned or your principal.

The less obvious way that you can lose money in a CD is through the eroding effect of inflation. When you lock your money into a CD with a fixed interest rate, you run the risk of the funds losing purchasing power if inflation outpaces the interest rate.

What happens when my CD matures? 

CDs mature on a specific date. At that point in time, you can collect the principal amount and interest earned, but the process varies by institution. It’s important to ask your bank or credit union how it provides notice that your CD is maturing and how much time you’ll have to collect.

The rules vary by bank or credit union on what happens to your CD if you don’t take action in time. A bank may reinvest your money into another CD with the same term. But some banks will automatically cancel the CD.

The frequency of interest payments on CDs varies by institution as well. Keep in mind that while interest might be compounded on a daily, monthly, quarterly or yearly basis, it might be paid out to your account on a different schedule.

Ally Bank, for example, compounds interest on a daily basis. But on CDs of 12 months or less, Ally credits interest to your account at maturity. For CDs more than 12 months, the online bank credits interest to your account annually. Barclays also compounds interest daily, but it credits interest to accounts on a monthly schedule.

Depending on your institution, you may have various options to collect the interest you earn. You might get the option to take regular interest disbursements or allow interest to accrue in the CD account. If you decide to take a regular disbursement, the way in which interest is paid (often by check or direct deposit) and when it is paid varies by bank as well.

For example, Barclays allows you to withdraw interest from your account on a monthly basis without penalty and transfer the funds to a Barclays online savings account or a verified external account. However, you can’t withdraw your principal until your CD matures. At Ally, you can have your accrued interest paid to you by check or transferred to another account on a monthly, quarterly, semi-annual or annual basis.

Bottom line

CDs are time-deposit investments. They function by holding your money for a specific period of time in exchange for a higher fixed interest rate than you’ll often find on traditional savings and money market accounts. If you’re looking for a safe shorter-term investment, CDs can be a great option.

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