How Do CDs Work? | Everything You Need to Know

Written by Kim PinnelliUpdated: 29th Sep 2021
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A CDis like a glorified savings account. The difference is you tie up your funds for a predetermined amount of time.

Savings accounts don’t penalize you like CDs do if you withdraw the funds earlier. But there’s a tradeoff – you earn higher interest rates.

Knowing how CDs work and what to expect can make making them a part of your financial plan easier.

How Do CDs Work?

A CD is like a savings account – but you earn a fixed rate of interest for a predetermined amount of time.

You must leave the funds in the account until maturity, and if you don’t, you’ll pay a penalty, which usually equals a couple of months of interest.

CD Rates

CD rates stay the same for the duration of the certificate. For example, if you invest in a 1-year CD, you earn the same APY for the entire year no matter how rates change.

CD Terms (Time Frame)

The term is how long you agree to tie up your funds. Using the 1-year CD example from above, you agree to keep your funds in the CD for 1 year.

If you withdraw earlier, you could pay a penalty for early withdrawal.

CD Maturity Date

On or around the CD maturity date, you have three options:

  • Withdraw the funds (no penalty)
  • Let the funds roll over into an identical CD for another term
  • Roll over the funds into a CD with a different term

CD Penalty

If you withdraw the funds early, you may pay a penalty. Read the fine print before you invest in a CD.

Some banks charge a week or so of interest and others charge as much as 12 months of interest as a penalty.

>> More: best cd rates

Are CDs Insured?

As long as you invest in a CD at an FDIC-insured bank, your deposits are insured up to $250,000.

Different Types of CDs

  • No-Penalty CD: If you must withdraw funds early or need the reassurance of being able to do so, a no-penalty CD may help. You can withdraw the funds whenever you want (with no penalty), but you’ll earn lower rates for it.
  • Jumbo CD: If you have $100,000 or more to invest, you may earn higher rates of interest in a jumbo CD, which has high minimum balance requirements.
  • Traditional CD: A traditional CD is any CD you invest in with a standard maturity, penalties for early withdrawals, and compounded interest.
  • IRA CD: You can make a CD a part of your retirement plan. Any interest you earn on the CD stays in the account and remains tax-deferred until you withdraw the funds in retirement.
  • Step-Up CD: If you want to ‘boost’ your earnings, a step-up CD pays your locked-in interest rate, but boosts the rate once or twice throughout the term, earning you more interest.

>> More:How to Build a CD Ladder

When Should I Get a CD?

Getting a CD at any time is a great way to increase your earnings. The best time to get a CD is when you’ve done the following:

  • Saved an emergency fund (3 – 6 months of expenses)
  • Maxed out your employer match on your 401K
  • Contributed the maximum allowed amount on your IRA
  • Paid off high-interest debt

If you still have money ‘left over’ to invest, a CD is a great way to keep it safe while allowing it to grow.

>> More:How to Open a CD

CDs vs. Savings Accounts

Savings accounts allow access to your money at any time with no penalty. CDs lock your funds up for the term or it costs you money to access it.

But, you’ll earn more money on a CD than you would in a savings account.

CDs vs. Money Market Accounts

Money markets are a cross between a checking and savings account. They are two different products, but the main difference is accessibility.

Money markets pay interest rates higher than regular savings accounts, but CDs pay more.

Money markets provide access to the funds via check, electronic withdrawal, or ATMs, whereas CDs lock your funds up for the term.

CDs vs Bonds

CDs are deposits in a bank account at an FDIC-insured bank. Bonds are loans to the government or companies.

They both have maturity dates, and the returns can be similar unless you invest in risky bonds which have a higher rate of return, but higher risk of default.

Bottom Line: How Do CDs Work?

A CD is a great way to earn interest on money you don’t want to invest but want more than the small return savings accounts offer.

Shop around for the CD with the best interest rates and terms and make the most of your investment.

Kim Pinnelli
Kim Pinnelli

Kim Pinnelli is a Senior Writer, Editor, & Product Analyst with a Bachelor’s Degree in Finance from the University of Illinois at Chicago. She has been a professional financial writer for over 15 years, and has appeared in a myriad of industry leading financial media outlets. Leveraging her personal experience, Kim is committed to helping people take charge of their personal finances and make simple financial decisions.