A CD is a savings account where you agree to leave money untouched for a set time in exchange for a higher interest rate
A certificate of deposit, or CD, is a contract between you and a bank. You give the bank a lump sum of money—say $5,000—and promise not to touch it for a specific period, called the term. In return, the bank pays you a fixed interest rate that is almost always higher than what you would earn in a regular savings account. When the term ends, you get your original money back plus the interest you earned.
The bank uses your money during that time to make loans and investments. Because the bank knows exactly how long it can hold your money, it can afford to pay you more interest than it would for a savings account where you can withdraw whenever you want. The tradeoff is simple: you get better interest, but your money is locked up.
Key Takeaways
- A CD requires you to deposit a fixed amount and leave it untouched for a set term, usually ranging from three months to five years.
- Banks pay higher interest rates on CDs than on regular savings accounts because they know they can use your money for the full term.
- If you withdraw money before the term ends, you will pay an early withdrawal penalty that reduces your earnings or principal.
- Your CD is insured by the FDIC up to $250,000, so your money is protected even if the bank fails.
- CD rates change based on what the Federal Reserve does with interest rates, so timing your purchase matters if you want the best rate.
How CD terms and interest rates work
When you open a CD, you choose the term length. Common terms are three months, six months, one year, two years, three years, and five years. Some banks offer longer terms or shorter ones. The interest rate the bank offers depends on the term: typically, longer terms come with higher rates because you are locking your money away for more time.
The interest rate on a CD is fixed, meaning it does not change during the term. If you buy a one-year CD at 4.5 percent, you will earn 4.5 percent for the full year, even if the bank's rates drop to 2 percent next month. This predictability is one reason people use CDs—you know exactly how much you will have when the term ends.
Interest on a CD is usually compounded daily or monthly and added to your account. When your term ends, the bank will either send you the money or automatically roll it into a new CD at the current rate. You can prevent the automatic rollover by telling the bank in advance what you want to do with the money.
What happens if you need the money early
The main drawback of a CD is that you cannot access your money without a penalty. If you withdraw before the term ends, you will pay an early withdrawal penalty. The size of the penalty varies by bank and by term length—it might be three months of interest, six months of interest, or a flat fee. On a short-term CD, the penalty could wipe out most or all of your earnings.
For example, if you open a one-year CD earning $200 in interest but withdraw after six months and face a six-month interest penalty, you might get back your original $5,000 but lose the $100 in interest you earned. Some banks allow you to withdraw a small amount without penalty, but this is uncommon and varies widely.
A few banks offer no-penalty CDs that let you withdraw early without a penalty, but they pay lower interest rates to offset that flexibility. These are worth considering if you are not certain you can leave the money alone for the full term.
FDIC protection and safety
Money in a CD is insured by the Federal Deposit Insurance Corporation, or FDIC, up to $250,000 per depositor per bank. This means if the bank fails, the FDIC will return your money up to that limit. This protection applies to the principal you deposited plus any interest you earned, as long as the total does not exceed $250,000.
If you want to protect more than $250,000 in CDs, you can open accounts at different banks—each bank's FDIC coverage is separate. You can also open CDs in different ownership categories at the same bank (for example, one in your name alone and one jointly with a spouse), and each category gets its own $250,000 protection.
How CD rates connect to Federal Reserve decisions
CD rates move up and down based largely on what the Federal Reserve does with its benchmark interest rate. When the Fed raises rates, banks typically raise CD rates within weeks. When the Fed cuts rates, CD rates fall. This means the best time to lock in a CD is when rates are high or when experts expect the Fed to cut rates soon—locking in a rate now protects you if rates drop later.
You can track the Fed's actions and economic forecasts through financial news sites or the Federal Reserve's own website. Many people watch the Fed's schedule of meetings to decide when to buy a CD. If the Fed is expected to cut rates, buying a CD now locks in a higher rate for your full term.
CD ladders and other strategies
Some people use a strategy called CD laddering to balance higher rates with access to money. Instead of putting all your money into one five-year CD, you split it into five one-year CDs. Each year, one CD matures and you can use that money or buy a new CD at the current rate. This gives you some flexibility while still earning CD rates on most of your money.
Another approach is to keep some money in a regular savings account for emergencies and put the rest in a CD. This way, you earn higher interest on the money you do not need immediately, and you have access to emergency funds without paying a penalty.
Frequently Asked Questions
Can I add money to a CD after I open it?
No. A CD is a fixed contract for a set amount. Once you open it, you cannot add more money to that CD. If you want to invest more, you would need to open a separate CD. Some banks let you open multiple CDs at the same time.
What is the difference between a CD and a savings account?
A savings account lets you withdraw money anytime without penalty, but it pays lower interest. A CD locks your money for a set term and pays higher interest, but you pay a penalty if you withdraw early. Choose a CD if you will not need the money; choose a savings account if you might need it.
Do I have to pay taxes on CD interest?
Yes. CD interest is taxable income. The bank will send you a 1099-INT form at tax time showing how much interest you earned. You report this on your tax return. The interest is taxed at your ordinary income tax rate, not at the capital gains rate.
What happens when my CD term ends?
When your term ends, the bank will notify you. You can withdraw the money, let it roll into a new CD at the current rate, or move it to another bank. Most banks give you a grace period of about seven to ten days to decide before automatic rollover happens.
Is a CD a good place to put emergency savings?
Not usually. Emergency money should be accessible without penalty. A regular savings account or money market account is better for emergencies. Use a CD for money you know you will not need for several months or longer.