Certificates of deposit: 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 do CDs 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.

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. 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. Some high-yield savings accounts can rival or beat out the highest CD rates. For example, currently the best nationally available 1-year CD is offering around 1.35 percent APY, while some of the best nationally available savings accounts currently offer around 1.50 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.

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 U.S. 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.

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.

“If you forget the CD matures, many times, the financial institution will automatically roll over the CD to a new CD,” says Rich Arzaga, certified financial planner and founder and CEO of Cornerstone Wealth Management in San Ramon, California.

Other institutions will cancel the CD automatically.

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.

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. Usually, the longer the CD, the higher the APY.

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

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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