What a CD is and how your money grows
A certificate of deposit (CD) is an account where you give a bank a sum of money for a set period of time—usually three months to five years—and the bank pays you a fixed interest rate on that money. You cannot touch the money during that period without a penalty. In exchange for locking your money away, the bank pays you more interest than it would on a regular savings account.
The bank uses your money during the time you have agreed to leave it there. That is why they pay you for the privilege. When your CD reaches its maturity date—the end of the agreed period—the bank returns your original deposit plus all the interest you earned, or you can roll the money into a new CD at the current rate.
The interest rate on a CD is set when you open it and does not change, even if the bank raises or lowers rates for other customers later. This predictability is one reason people choose CDs: you know exactly how much money you will have at the end.
Key Takeaways
- A CD locks your money for a fixed term in exchange for a may provide interest rate higher than a savings account offers.
- You pay a penalty if you withdraw money before the maturity date, usually equal to several months of interest.
- Interest compounds—meaning you earn interest on your interest—and is added to your account at regular intervals, typically monthly or quarterly.
- When your CD matures, you receive your original deposit plus all earned interest, and you can then open a new CD or move the money elsewhere.
- CD rates vary by bank, term length, and deposit amount, so comparing offers before you open one saves money.
How interest accrues and compounds on your CD
The interest rate the bank quotes you is an annual percentage rate, or APY. This is the actual return you will receive in one year, accounting for how often the bank adds interest to your account. If a CD offers 4.5% APY, you will earn 4.5% of your deposit over twelve months.
Interest compounds, meaning the bank calculates interest on your original deposit plus any interest already earned. If you deposit $5,000 in a one-year CD at 4.5% APY, after six months you might have $5,112.50 (half the annual interest). In the second six months, the bank calculates interest on $5,112.50, not just the original $5,000. By the end of the year, you will have earned slightly more than $225 in total interest.
How often the bank compounds interest—daily, monthly, or quarterly—affects the final amount slightly. Daily compounding earns you a bit more than monthly compounding at the same APY. The bank discloses the compounding schedule when you open the account.
Early withdrawal penalties and what they cost
If you need your money before the CD matures, the bank will let you withdraw it, but you will pay a penalty. The penalty is usually stated as a number of months of interest. A common penalty is three months of interest, meaning if you withdraw early from a CD that would have earned $200 in interest, you lose $50 (three months' worth).
Some banks charge a flat dollar amount instead—for example, $25 or $50—regardless of how much you have in the CD. A few banks charge a percentage of your deposit. Always ask the bank what the early withdrawal penalty is before you open a CD, because it varies widely and can make a real difference if you think you might need the money.
The penalty comes out of your interest earnings first. If your penalty is larger than the interest you have earned so far, it comes out of your principal—the money you originally deposited. This is rare with short-term CDs but can happen if you withdraw very early from a long-term CD with a steep penalty.
CD terms and how to choose the right length
Banks offer CDs in many term lengths: three months, six months, one year, two years, three years, and five years are common. Some banks offer terms as short as one month or as long as ten years. The longer the term, the higher the interest rate the bank typically offers, because you are committing your money for a longer time.
If you choose a short-term CD—say, three or six months—you will earn less interest but you will have access to your money sooner. If you choose a long-term CD—say, three or five years—you will earn more interest but your money is locked away longer. There is no right choice; it depends on when you think you will need the money and how much interest you want to earn.
Some people use a CD ladder to balance these two goals. They open multiple CDs with different maturity dates—for example, one CD maturing in one year, one in two years, and one in three years. As each CD matures, they can withdraw the money, reinvest it in a new long-term CD, or move it elsewhere. This way they earn higher rates on longer terms but still have money becoming available regularly.
What happens when your CD matures
On the maturity date, your CD stops earning interest. The bank will send you a notice a few weeks before the date, telling you what happens next. You have a choice: you can let the bank automatically roll the money into a new CD at the current rate, or you can withdraw the money or move it to another account.
If you do nothing and the bank rolls your money into a new CD automatically, you will be locked in for another term at whatever rate the bank is offering at that time. That rate might be higher or lower than your original rate. Many banks give you a grace period—usually seven to ten days—after maturity to withdraw your money without penalty if you change your mind about rolling it over.
When your CD matures, the bank adds all the interest you earned to your account. You can then withdraw the full amount (original deposit plus interest), move it to a different bank, or open a new CD. There is no tax withholding on the interest at the bank level, but you will owe income tax on the interest when you file your tax return.
How CD rates compare across banks and what affects them
CD rates vary significantly from bank to bank. A one-year CD at one bank might pay 4.0% APY while another bank pays 4.75% APY for the same term. Over one year, that difference adds up: on a $10,000 deposit, the higher rate earns $75 more. Online banks and credit unions often offer higher rates than large national banks because their overhead is lower.
Rates also depend on the term length and the size of your deposit. Longer terms usually pay more. Some banks offer higher rates on larger deposits—for example, 4.5% on deposits under $25,000 and 4.75% on deposits of $25,000 or more. A few banks offer special promotional rates for new customers or for opening multiple CDs at once.
National interest rates set by the Federal Reserve affect all CD rates. When the Fed raises its benchmark rate, banks raise CD rates. When the Fed lowers rates, CD rates fall. If you are considering a CD, checking current rates at several banks—your current bank, online banks, and local credit unions—takes fifteen minutes and can save you hundreds of dollars in interest over the life of the CD.
FDIC insurance and what it protects
Money in a CD at a bank insured by the FDIC (Federal Deposit Insurance Corporation) is protected up to $250,000 per depositor, per bank. This means if the bank fails, the FDIC will return your deposit and all earned interest up to $250,000. If you have multiple CDs at the same bank, the $250,000 limit applies to all of them combined, not to each one separately.
If you have more than $250,000 to invest in CDs, you can open accounts at different banks to keep each one under the insurance limit. Credit unions have similar protection through the NCUA (National Credit Union Administration), also up to $250,000 per account holder per institution.
FDIC insurance does not protect you from early withdrawal penalties or from interest rate risk—meaning you cannot sue the bank if rates drop after you open your CD. It protects only against the bank failing and being unable to return your money.
Frequently Asked Questions
Can I withdraw money from a CD before it matures?
Yes, but you will pay an early withdrawal penalty. The penalty is usually several months of interest or a flat dollar amount. The exact penalty depends on your bank and your CD's terms. Ask your bank for the specific penalty before you open the CD.
What is the difference between a CD and a savings account?
A savings account lets you withdraw money anytime without penalty, but it pays much lower interest. A CD locks your money for a set term and pays higher interest, but you lose money if you withdraw early. Choose a CD if you will not need the money for several months or longer.
Do I pay taxes on CD interest?
Yes. The interest you earn on a CD is taxable income. The bank will send you a 1099-INT form in January showing how much interest you earned in the previous year. You report this on your tax return and pay income tax on it at your regular tax rate.
What happens if I do not do anything when my CD matures?
Most banks automatically roll your money into a new CD at the current rate for the same term length. You usually have a grace period of seven to ten days after maturity to withdraw the money or move it without penalty if you do not want the new CD.
Should I open a CD now or wait for rates to go higher?
No one can predict whether rates will rise or fall. If current rates meet your needs and you will not need the money during the term, opening a CD now locks in that rate. If you think you might need the money soon, a shorter-term CD lets you reassess when it matures.