What Is a Certificate of Deposit and How Does It Work?

Chances are you’ve heard about savings accounts, but there’s another common savings product you may not be as familiar with: certificates of deposit, or CDs. CDs often pay a higher yield than savings accounts, and their rates are fixed, unlike savings account rates, which can vary at any time.

But there is a tradeoff: You’re promising the bank that you won’t need to withdraw the money until a specified date in the future. Read on to learn how CDs work, where you can find the best CD rates and what to consider before you open one.

What is a certificate of deposit?

A certificate of deposit, or CD, is a savings option that pays a fixed interest rate, typically offered by a bank or credit union. You agree to deposit a lump sum of money, known as the principal, for a certain amount of time, known as the term.

You’ll often earn a higher APY with a CD than you would from a typical savings account, and there’s less risk involved than with other investments like mutual funds.

On the downside, CDs aren’t as flexible as savings accounts. If you need to access your money before the term ends -- known as the CD’s maturity date -- you’ll often have to pay an early withdrawal penalty equal to a few months of interest.

The longer the terms of your CD, the more interest you’ll generally earn. CDs have terms starting at one month and ranging up to five or 10 years.

How does a CD earn interest?

CDs earn compound interest, which means you earn interest not just on the principal balance, but also on the interest you’ve earned so far. Many banks compound interest on their CDs on a daily or monthly basis.

The compounding frequency and the CD’s interest rate are reflected in the annual percentage yield, or APY, which is locked in when you open the CD. Because of their fixed rate, it’s easy to calculate the return you stand to earn from a CD.

What are the different types of CDs?

Along with a traditional CD, where you invest a lump sum for a specific period, there are a variety of CDs with special rules and benefits. For example, an IRA CD gives investors tax advantages for retirement but raises the danger of an extra IRS penalty for early withdrawals.

Among many other CD options, a foreign currency CD exchanges your money for that of another country’s currency until it matures, when it transfers back to dollars. A zero-coupon CD eschews APY and instead guarantees a specific value for the CD when it matures. A no-penalty CD also offers more flexibility, letting you withdraw your funds early without incurring an early withdrawal penalty.

Bump-up CDs let you boost APYs one time if interest rates rise, and add-on CDs let you invest more money during the length of the CD’s term. Each type has its own rules and requirements, which typically vary by bank and CD term.

What is the best CD term length?

It all depends on when you think you’ll need to access your money.

If you’re planning to buy a car in a few years, putting your car fund money in a three-year CD may be a safe bet. But if your vehicle is on its last legs, don’t tie too much into a CD.

If you’re saving for the distant future and won’t need the money anytime soon, look for the highest CD rate you can find, usually with five-year terms or longer.

And always make sure you have an emergency fund set aside in an easily accessible account.

Are CDs insured?

Most CDs offered by banks are insured up to $250,000 per issuer, per bank for each account category by the Federal Deposit Insurance Corporation. The CD equivalent issued by credit unions, often referred to as share certificates, are insured for the same amount but by the National Credit Union Administration. Before opening a CD, make sure the financial institution is FDIC- or NCUA-insured.

Foreign currency CDs typically aren’t covered by the FDIC, and some brokered CDs aren’t, either.

What is a CD ladder?

A locked APY is good news if interest rates take a nosedive. But if they go up, you could miss out.

Buying multiple CDs of varying term lengths, known as CD laddering, enables you to take advantage of either eventuality. It also ensures at least some of your money will be available soon should an unexpected need arise.

Where can I buy a CD?

You can find a variety of CD options at traditional banks, online banks and credit unions.

You can also buy CDs through brokerage firms, which purchase them from the banks. If you buy a brokered CD on this secondary market, you can sell it before its maturity date without incurring a penalty -- but you may have to pay a brokerage fee.

Correction: An earlier version of this article was assisted by an AI engine and it mischaracterized some aspects of savings accounts and higher-risk assets. Those points were all corrected. This version has been substantially updated by a staff writer.