A certificate of deposit (CD) is a type of savings account that offers predictable growth. With this savings strategy, you’ll benefit from federal protection, fixed interest rates, and guaranteed earnings.

Read on to explore what a CD is and how it works. We’ll also discuss important factors to help you decide if you should purchase one.

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What does certificate of deposit mean?

By definition, a certificate of deposit is a contract between you and your financial institution. You agree to keep a lump sum in a savings account for a set time period, typically between six months and two years. In exchange, you’ll earn interest as the funds mature. You pay a penalty if you withdraw your money before the period ends, but there’s no penalty if you wait until the maturity date. 

You can buy CDs from banks, credit unions, or brokerages. These savings accounts are typically considered safe, as the Federal Deposit Insurance Corporation (FDIC) insures bank-issued CDs for up to $250,000. And if you purchase one through a credit union, the National Credit Union Administration provides the same level of coverage. 

If you’re setting aside funds for a specific goal, such as buying a new car, making a down payment on a house, or saving for retirement, you can choose a certificate of deposit with a term that aligns with your timeline. Your money can earn more interest than a standard savings or money market account.

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How do CDs work? CD accounts explained

If CDs fit into your financial plan, it’s important to understand the details before contributing. Here’s how they work:

1. Initial deposit: You deposit a lump sum into the CD account.
2. Lock-in period: The bank holds your funds for the agreed term.
3. Interest accrual: Your money earns interest at an agreed-upon rate.
4. Maturity: You receive your initial deposit back plus earned interest.

The interest on your CD account compounds, meaning you earn returns on your initial deposit and previously earned interest. Most banks offer daily or monthly compounding, which helps your money grow faster. 

To see how this works in action, consider the following certificate of deposit example. Say you allocate $10,000 in a 12-month CD with a 4% APY — your earnings will accumulate as follows:

• Monthly interest rate: 0.333% (4% annual rate divided by 12 months)
• Total interest after one year: $407.44
• Final balance at maturity: $10,407.44

When your CD’s term ends, you can withdraw your funds, roll them into a new CD, or combine these strategies. It’s important to note that you may be subject to income taxes on your earnings but not the principal.

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3 types of CDs

When deciding which types of CDs is right for you, you may consider one of these three popular options.

1. IRA CDs

Individual Retirement Accounts (IRAs) are designed to help you save for retirement. There are two types: Traditional and Roth. The primary difference between these accounts lies in when you pay taxes. Traditional IRA contributions are tax deductible, but you’ll need to pay income tax on future withdrawals. In contrast, you’ll fund Roth accounts with after-tax dollars. While this won’t give you any benefits now, it means you’ll have access to tax-free money in retirement.

No matter which type you choose, you need to actively invest your money. Otherwise, your IRA won’t earn interest, essentially turning it into a regular savings account. 

One option is moving some of your holdings into a CD. With this strategy, your CD will benefit from the aforementioned tax benefits, and your IRA contribution will be protected by the $250,000 FDIC or NCUA insurance. This combination offers a reliable choice for individuals close to retirement who want guaranteed returns. 

2. High-yield CDs

High-yield CDs offer better-than-average interest rates compared to standard CDs. You’ll often find these certificates of deposits at online banks with lower operating costs so that they can offer more competitive interest rates. Other than these differences, high-yield accounts work the same way as traditional accounts, so there aren’t really any downsides to looking for the highest interest rate possible.

3. No-penalty CDs

A no-penalty certificate of deposit allows early withdrawals without losing interest, typically after the first week. It offers flexibility for unexpected needs, can provide better rates than standard savings accounts, and protects your earnings even if interest rates drop. And if you find a CD offering higher returns, you’re free to roll your money over into a different account.

Despite these benefits, opening a no-penalty CD also has some drawbacks. One issue is withdrawal limits: Many institutions don’t allow you to take out partial funds. This all-or-nothing approach means that even if you only need a bit of money, the rest can’t stay in the bank to grow. And although no-penalty CDs typically offer higher rates than savings accounts, they tend to be lower than the locked-in rates of traditional savings accounts.

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Top benefits of CDs

CDs can be a great way to grow your savings — here are three benefits that set them apart.

Better earnings 

CDs typically offer much better returns than traditional savings accounts, helping your money grow faster. And even if you opt for high-yield savings, the interest isn’t fixed, which can lose you money when the Federal Reserve lowers rates.

Predictable returns 

With CDs, you lock in a fixed rate, so you’ll know exactly how much you’ll earn by the end of the term. Say you deposit $10,000 into a 12-month CD at 5% APY. Monthly compounding interest guarantees you $511.62 in earnings by the end of the year.

Ladder options

You may also consider using CD ladders, opening multiple accounts with varying maturity dates. This offers regular access to funds, lets you lock in high rates when they’re available, and protects you from downturns when rates drop.

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Key disadvantages of CDs

CDs provide stability but also have drawbacks you should consider. Here are three of their limitations.

Limited access to funds 

Once you deposit money into a CD, withdrawing it before the term ends can be difficult. Early withdrawals usually result in penalties, which might include: 

• Less income: Losing several months’ worth of interest earnings
• Lowered principal: Potentially reducing your deposit in rare cases
• Lost rates: Forfeiting unique rate benefits tied to the CD

Impact of inflation 

If your CD’s interest rate is lower than the inflation rate, your money’s purchasing power declines over time. For example, a CD might earn only 3% after taxes, which may not keep pace with rising inflation.

Missing out on higher rates 

Locking in a fixed-rate CD ties your money to lower APYs. While this can be a benefit when rates drop, it also prevents you from accessing CDs with better returns.

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3 factors to consider on a CD

When choosing a CD that meets your financial needs, there are three top factors to consider.

1. Interest rates

Current rates range from 4.30% to 5.25% APY for a one-year term. These change based on factors like Federal Reserve interest rates, the bank or credit union you choose, and competition in the market.

2. Deposit amount

Minimum deposit requirements differ between institutions. Some have no minimums, while others set thresholds ranging from $500 to $100,000. Before agreeing to a contract, ensure that you have an adequate deposit that fits the bank’s criteria.

3. CD term

The term length you choose impacts both accessibility to your money and your potential earnings. On average, there are three types of term lengths:

• Short-term CDs (3–12 months): Offer greater flexibility
• Mid-term CDs (2–3 years): Balance accessibility and returns
• Long-term CDs (4–5 years): Historically provide higher rates

Many banks offer higher APYs on one-year CDs than five-year CDs. Consider setting up a CD ladder to enjoy different interest rates and maturity dates. This way, you can balance your need for flexibility with the potential for earning more.

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Practical certificate of deposit examples

To understand how CDs work in real life, let’s walk through a couple of hypothetical examples with varying contribution amounts, terms, and scenarios.

Example 1: Earning with a five-year CD

Suppose you deposit $5,000 in a five-year CD with a 5% APY. Over time, compound interest helps your savings grow. Here's how your earnings would look year by year (rounding the totals):

• Year 0: Initial deposit: $5,000
• Year 1: Earn $250 in interest. Balance grows to $5,250
• Year 2: Earn $263 in interest. Balance grows to $5,513
• Year 3: Earn $276 in interest. Balance grows to $5,789
• Year 4: Earn $289 in interest. Balance grows to $6,078
• Year 5: Total earnings are $1,382. Final balance is $6,382

Example 2: Early withdrawal scenario

Now, let’s consider a different situation. Imagine you deposit $10,000 in a five-year CD at a 5% APY but need to withdraw after three years. While you earn interest during that time, withdrawing before maturity leads to a penalty. Here’s how it works:

• Total interest earned: $1,576
• Early withdrawal penalty: $276 (equal to 6 months’ interest)
• Net earnings after penalty: $1,300

Despite the penalty, you still benefit from the account. This example shows why planning your CD term is important to avoid penalties.

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This communication is for informational purposes only. It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice.