How Does a CD Account Work?

Certificates of deposit (CDs) have different rules than other types of accounts

If you're planning to make a big purchase in the next few years and have some of the money on hand now, you might consider putting it into a certificate of deposit (CD). A CD can be thought of as a federally insured savings account, but with a few key differences. With a CD, you agree to leave your money in the account for a set period of time, which can range from a few months to a number of years. In exchange, the bank or credit union that issues your CD will pay you a guaranteed return on the money, typically higher than you'd get on a regular savings account. In this article, we'll explain how CDs work and how you can make them work for you.

Key Takeaways

  • Certificates of deposit (CDs) can be a safe place to put money aside until you need it while earning some interest in the meantime. 
  • CDs work differently from other bank and credit union accounts. They pay higher interest rates but also lock your money in for whatever term (or length) you've agreed to.
  • If you have to take money out of your CD before it matures, you will generally be subject to early-withdrawal penalties.
  • CDs can vary widely from one financial institution to another in their interest rates and other features.

Before You Open Your CD Account

A certificate of deposit is a relatively simple investment product and buying one is a pretty straightforward process. Even so, there are a few important things to consider.

1. Decide how much you want to invest

First of all, you should consider how much money you can invest in a CD. This is important because CDs are not very liquid—that is, you can't get your money out easily if you need it in an emergency. Because of this, you should only put money into a CD that you are fairly sure you are not going to need before the CD matures. CDs have early-withdrawal penalties (more on that below), which makes them a bad choice for emergency savings or other money you might want at a moment's notice.

2. Determine what kind of CD you want

Virtually every bank and credit union in the U.S. offers at least one certificate of deposit and many have a wide array of them. Not only is your local brick-and-mortar bank a potential source for your CD, but so is every bank or credit union in your community, as well as every bank that accepts customers nationwide via the internet. Investopedia's regularly updated rankings of the best bank CD rates, for example, track about 200 banks that offer CDs.

There are three main considerations when choosing a CD. The first is the term you want to hold it for—in other words, how long you are willing to leave your money in the CD before you can get at it again. CD terms range from a few months to a few (or even many) years. If you aren't sure when you're likely to need your money back, it's better to err on the side of caution. You can always choose a CD with a short term and then re-invest the money in another CD after it matures.

Interest rates are another consideration. Longer terms generally mean higher rates. But the range of CD rates can vary widely from one financial institution to another. The top-paying CDs in the country can pay three to five times the national average rate, so it's smart to shop around.

Finally, consider whether a standard or more specialized type of CD would be best for you. The standard CD pays a set interest rate and charges penalties for early withdrawals. There are other types that pay variable interest rates or that are more flexible, such as liquid CDs. In general, you'll pay extra for that flexibility through a lower interest rate.

After You've Opened Your CD Account

Let's say you've purchased the CD you've chosen. Then what?

1. Try to leave your money alone

Now comes the (potentially) easy bit: leaving your money alone. Once you've signed up for a CD, your bank or credit union will give you instructions on how to transfer funds to the new account. Once you've done that, try to resist the temptation to withdraw money before your CD matures, unless you face a genuine emergency. 

The early-withdrawal penalty on a typical CD can be substantial, in some cases exceeding any interest you've earned. So you could even lose some of the money you invested in the first place.

2. Plan for when your CD matures

When your CD reaches the end of its term, you'll have some decisions to make. Normally, you will have three options: 

  • Roll the CD over into a new CD at that bank or credit union. You can choose a CD of the same term or a different one.
  • Transfer the funds into another account at that bank. Your options include a savings, checking, or money market account.
  • Withdraw the proceeds. You can ask the financial institution that holds your CD to transfer the money to an account at a different institution or mail you a check to deposit yourself.

If you don't provide any instructions before the bank or credit union's deadline, it will usually roll your CD proceeds into a new CD of the same term. If that's not your intention, missing the deadline could mean locking yourself into a CD with a subpar rate or paying an early-withdrawal penalty to get your money out.

How Much Money Do You Need to Invest in a CD?

Many banks and credit unions require at least a certain minimum amount to open a CD, such as $500 or $1,000, but some set no minimum.

Can You Lose Money in a CD?

It's very unlikely. CDs are considered one of the safest investments around. Your bank or credit union assumes all the risk for delivering the interest rate it promises you and most CDs are federally insured up to certain limits.

Do CDs Pay Interest Monthly?

How CDs pay interest varies by account. Some CDs pay interest monthly, weekly, or even daily. Others pay all the interest at the end of their term.

Can You Add Money to Your CD Account?

Not usually. Most CDs require a one-time investment and you can't add to it later. You can, of course, buy another CD if you have additional money. One exception is called an add-on CD, although they are uncommon compared with standard CDs.

The Bottom Line

Certificates of deposit (CDs) work differently from other types of accounts offered by banks and credit unions. They typically pay higher interest rates but also require that you leave your money on deposit for an agreed-upon period of time. Otherwise, you'll usually have to pay an early-withdrawal penalty.

Article Sources

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  1. U.S. Securities and Exchange Commission. "Certificates of Deposit."

  2. Office of the Comptroller of the Currency. "What Are the Penalties for Withdrawing Money Early From a Certificate of Deposit (CD)?"

  3. Consumer Financial Protection Bureau. "What Is a Certificate of Deposit (CD) Rollover or Renewal?"