What Is a Certificate of Deposit (CD)?

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Updated on Wednesday, October 6, 2021

A certificate of deposit (CD) is a type of savings vehicle that locks in a specific amount of money for a specific period of time, known as a term. In exchange for locking up your money for a fixed period of time, banks, credit unions and other financial institutions offer a higher interest rate for CDs than regular savings accounts. CD terms range from one month to five years or more. Generally, the longer the term, the higher the interest rate.

What is a certificate of deposit (CD)?

A CD is an investment for savings, and these accounts generally offer higher interest rates than savings accounts. As a result, your money grows more in a CD than it does in a savings account. Interest rates on CDs are usually fixed, but some institutions may offer variable rates.

CDs are very safe repositories for your money because the principal (the money initially deposited) never fluctuates. Money invested in stocks, on the other hand, can rise or fall, and bond prices fluctuate with interest rate changes. CDs also offer protection against falling interest rates: a fixed-rate CD offers the same rate throughout the term. Finally, CDs at a bank are insured for up to $250,000 by the Federal Deposit Insurance Corporation (FDIC); the National Credit Union Administration (NCUA) insures them for the same amount if the account is with a credit union. This insurance protects your money against any bank or credit union failure — which are extremely rare, but they do occur.

CDs do have potential disadvantages. If you need the money before the term is up, you will likely pay a penalty for an early withdrawal. Another potential drawback? If interest rates rise and you’ve invested in a fixed-rate CD, you’ll miss out on more interest for the duration of the term. You also can’t periodically increase your savings in the CD because the amount invested is fixed. Finally, while not necessarily a disadvantage, be aware that you will need to pay taxes on interest earned on a CD, as you do with other deposit accounts.

Pros and cons of a CD

To find out whether a CD is a good fit, you need to assess the pros and cons.

Pros:

Cons:

Interest rates for CDs are usually higher than for savings accountsRestricts your access to the cash; early withdrawal is likely to incur a penalty
Interest rates on fixed-rate CDs remain stable over the term which protects investors against falling interest ratesCan miss out on increases in interest rates if they rise during the CD’s term
Safety of principal. No risk of losing money due to fluctuations in prices, unlike stocks or bondsCan’t add money whenever you want
Insured for up to $250,000 by FDIC or NCUA

CDs vs. savings accounts

Both CDs and savings accounts are savings vehicles that can be opened at a bank, credit union or other financial institution. Savings accounts pay interest and are insured by the FDIC or NCUA for up to $250,000. Interest rates for savings accounts are generally lower than for CDs.

Why might you choose one account over the other? The choice largely depends on how and when you plan to use the money.

With savings accounts, you can regularly deposit and withdraw money (subject to any minimums or transaction limits). That’s why these accounts may be the better option if you are building up savings and want to deposit a certain amount every month or you plan to use the money as an emergency fund, in case you suddenly need to pay for an unplanned expense like a car repair. What’s more, if you think interest rates will rise in the short term, you might want to deposit money in a savings account, because you’ll earn more interest if that happens. This is especially true if you choose a high-yield savings account, which offers a higher interest rate than conventional savings accounts.

By contrast, CDs require fixed terms for deposits, you will earn a fixed-rate for interest and you will likely pay penalties if you withdraw money early. That’s why a CD may be a better choice if you want to save money for a long-term goal, like a home down payment, or if you think interest rates might stay the same or drop because you’ll lock in a fixed-rate with a CD.

What are the different types of CDs?

Financial institutions offer many different types of CDs, including:

  • Traditional CDs: A savings account that locks in a fixed amount of money for a fixed period of time.
  • No-penalty CDs: A no-penalty CD allows you to withdraw money. Interest rates may be lower than in a traditional CD, but still higher than savings account rates.
  • Jumbo CDs: A jumbo CD requires a large minimum deposit to open, usually at least $100,000, although some institutions may require less.
  • High-yield CDs: This type of CD offers a higher interest rate than a traditional CD, though it may be slightly riskier.

What is a CD ladder?

A CD ladder is a method of structuring the CDs you buy to harness specific benefits, (like a safe way to invest money and higher interest rates for longer terms), while protecting against potential drawbacks (like the risk of being locked out of any interest rate increases and relative lack of access to your money). In addition, CD ladders can benefit you if rates rise, because they allow you to capture the increase over time.

The structure is easiest to understand through an example. Let’s say you have $10,000 to invest and want a five-year ladder, with the ultimate goal of having a new five-year CD mature every year. You start your ladder by investing the following:

  • $2,000 in a one-year CD
  • $2,000 in a two-year CD
  • $2,000 in a three-year CD
  • $2,000 in a four-year CD
  • $2,000 in a five-year CD

When your one-year CD matures, you place the money into a five-year CD. Then, as CDs mature in each subsequent year, you take each one and invest it into a new five-year CD. At the end of the period, you’ll have a five-year CD maturing each year. Your five-year CDs will have higher interest rates than those in lesser-term CDs, and if interest rates rise over the period, you have the opportunity to lock those in each year when a CD matures.

Plus, because you have a CD maturing every year, you have access to $2,000 without penalty annually if you need it.

You can structure a CD ladder with any set of multiple years and amounts, depending on how much you have to invest.

How do I open a CD?

It’s easy to open a CD. The most important step is shopping around to make sure you get the benefits you want. If you’re after high interest rates, consult the latest information on the best CD rates. Once you’ve selected the best CD for you, the process is somewhat like opening a bank account. You’ll need to complete an application — online, in person or by phone. Check with the institution to see what you’ll need to complete; most require the following information:

  • Valid forms of identification, like a driver’s license
  • Social Security number
  • Birth date
  • Address
  • Phone number
  • E-mail

Submit the completed application along with your deposit. For the deposit, you will need to provide either a check or the routing and account numbers for an electronic transfer. Finally, you will need to sign forms from the bank specifying the term, interest rate, maturity date and other information from the bank. Once your CD is open, you can check the balance and interest you’re earning each month, just as you would with any other savings account.