How does a certificate of deposit (CD) work?
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- CDs earn interest by keeping money in the account for a set time period.
- Traditional CDs are the most common account available, but some banks also have specialty CDs.
- CDs have several features to assess, including interest rates and early withdrawal penalties.
Making informed financial decisions often begins with understanding your options. A certificate of deposit (CD) is one banking tool you can use to grow your savings.
We'll cover everything you need to know about these accounts so you can understand how CDs work, including diving into specific features such as CD rates, types, opening requirements, and penalties.
How do CDs work?
CDs are interest-earning bank accounts. CDs work by paying you interest on the money in your account.
Christopher Stroup, CFP and financial advisor at Abacus Wealth Partners, says a CD may be a good place to store emergency reserves. Stroup also recommends that people match a CD with a specific savings goal. When choosing a CD, think about which features can help support your goal. One way to narrow down your options is to consider how long you can keep money in the account without needing to make a withdrawal.
Below are terminology and features you should know to learn more about how CDs work.
CD types
Here's a brief overview of the different types of CDs available across financial institutions. The most common type of account you'll find is a traditional CD. However, many financial institutions also have specialty CDs — unique variations of the standard account option. Also, take note CDs do not have any monthly bank maintenance fees.
| Type of CD | How it works |
Traditional CDs | It permits a one-time deposit. A financial institution pays the same interest rate on your account for the entire term. If you withdraw money before the term ends, the bank charges a penalty. |
| It has the same features as a traditional CD, except it pays a higher rate with the requirement of a higher opening deposit (often $100,000 or more). | |
| This is a type of retirement investment account. There are traditional, Roth, and SEP IRA CDs. IRA CDs have many of the same rules as other IRAs. | |
| It's available at a brokerage firm. They don't compound interest and or have early withdrawal penalties. If you want to withdraw money early, you have to sell it in a secondary market. | |
| This CD does not charge any penalties for early account withdrawals. It still has a fixed interest rate and only permits a one-time deposit. | |
| This is the only type of CD that permits additional deposit after opening an account. It still has a fixed interest rate and early withdrawal penalties. | |
Variable-rate CDs | It has an interest rate that changes during the term. These CDs only permit a one-time deposit and have early withdrawal penalties. Some examples of variable rate CDs include step-up CDs and bump-up CDs. |
CD opening requirements
The process for opening a CD is pretty straightforward. You can open an account at a bank, credit union, or brokerage firm. You must be at least 18 years old to open an individual bank account. If you're getting a CD for a minor, a legal guardian or parent can open a joint bank account with the child.
When you open a CD, you will need to provide personal information and documentation, like a government ID, Social Security number, and proof of address. There are also banks and credit unions that make it easy for immigrants and non-US citizens to open an account.
The standard minimum opening deposit for CDs is $1,000. However, select financial institutions let you open a CD with $0.
CD terms
CDs are open for a term. A term is how long you'll keep money in an account and earn a fixed interest rate. For example, if you open a 1-year term, you would earn the same interest rate for 12 months.
Most financial institutions offer traditional CDs for terms between six months and five years.
CD maturity
Once your CD term is about to end — or "reach maturity" — you'll have the option to make changes to your account. This is referred to as a grace period by financial institutions. The grace period for a CD usually lasts around 10 days.
You'll have the option to withdraw money or close an account. If you'd like to keep money in a CD, you could also choose to renew the term.
CD interest rates
Most types of CDs offer a fixed interest rate. This means the rate will stay the same for the term. For example, if you opened a 1-year CD paying 5% APY, you'd earn 5% APY for 12 months — it wouldn't increase or decrease during that time.
If you open a variable-rate CD, the interest rate on your account may fluctuate over time. These CDs may offer a guaranteed rate increase at a specified date, require you to request a rate change, or alter the rate automatically according to the federal funds rate.
CD early withdrawal penalties
If you need to take out money from a CD before the term ends, most types of accounts charge an early withdrawal penalty. The penalty for an early withdrawal is often paying back some of the interest you earned.
Stroup says one strategy used to offer more liquidity is creating a CD ladder. You can build a CD ladder by splitting your deposit into multiple CDs of different terms instead of putting it all into a longer-term CD and risk needing to withdraw funds early.
"In terms of maintenance with the CD ladder, one of the things the consumer may want to be mindful of are those maturity dates," adds Stroup.
Stroup recommends checking in with your financial goals when each CD is about to reach maturity and seeing if you want to reinvest or withdraw your money. You might decide you need to have access to more cash, then move the money to a savings or checking account.
Federal insurance for CDs
CDs are safe, low-risk savings options because they are offered by federally insured banks and credit unions. If a financial institution is federally insured, up to $250,000 per depositor, per account category is secure in a bank account. If a bank or credit union collapses, your insured deposits are protected by the FDIC or NCUA.
If you want to deposit more than $250,000 in a CD, there are still ways to make sure your money is protected and insured. You could open an individual bank account and a joint bank account at the same financial institution. Another option is to open bank accounts at different banks and credit unions. Keep in mind there are benefits and drawbacks to opening a joint bank account versus an individual account or opening bank accounts at multiple banks.
Taxes on CDs
CDs are taxable, and you'll report interest earned on your account when you complete your annual tax return. Financial institutions will send a 1099-INT form by January 31 if you earned more than $10 in interest. If you do not pay taxes on CDs, you may face a penalty by the IRS.
How CDs work FAQs
How do CDs make you money?
CDs make you money by paying interest on funds that are kept in the account.
Does a CD pay monthly?
Many CDs pay interest monthly. Interest is often deposited into the account at the end of each statement period. However, some financial institutions may pay interest quarterly or annually instead.
Is it worth putting money in CDs?
It may be worth putting money into a CD if you do not need immediate access to some of your savings. Choosing a CD depends on the timeline of your goal and what you're saving for.
How much does a $10,000 CD make in a year?
If you deposit $10,000 into a CD for a year, the amount of interest you'll earn will depend on the current rate and how frequently the interest is compounded on the account. That said, if you deposited $10,000 into a 1-year CD paying 6% APY, you'd make about $600 in interest.
How much does a $5,000 CD make in a year?
If you deposit $5,000 into a CD for a year, the amount you'll make will depend on the current rate and how frequently the interest is compounded. If you deposited $5,000 into a 1-year CD paying 6% APY, the total interest earned would be around $300.