How Do CDs Work?

CDs are safe investments that usually earn a higher interest rate than savings accounts. However, they typically require a longer commitment and you don’t have access to your cash during the term of the CD. 

They are good mid-term investments. Use them if you don’t expect to need your cash for at least a year, but may need it within five years. 

How Do CDs Work?

Bank CDs are similar to savings accounts as they are FDIC-insured up to $250,000 and you can earn interest monthly. But CDs have stricter withdrawal policies and can require a higher initial deposit.

Here are three factors to consider when opening a bank CD:

  • CD term: The number of months before you can withdraw your funds penalty-free
  • Interest rate: The annual percentage yield (APY) you will earn for the entire CD term
  • Minimum deposit: Most banks require an opening deposit between $0 and $1,000

Like your savings account deposits, banks lend your CD deposit to borrowers and collect interest payments. CDs offer higher interest rates than most savings accounts because you commit to investing your cash for a specific number of months. If you redeem your cash before the CD term matures, you will most likely pay an early redemption penalty.

For example, a 12-month term CD requires you to invest your cash for one year. Withdrawing your cash before the CD matures can result in an early redemption fee. In this instance, the penalty is three months of interest income.

When the CD matures, you can withdraw your initial deposit and interest earnings. You also have the option of renewing your CD for a new term. Keep in mind that your new CD’s interest rate can be higher or lower than the original CD term.

Some banks offer a penalty-free CD allowing you to make hassle-free early redemptions. However, your interest rate is likely to be lower than a traditional CD.

Tip: CIT Bank offers term CDs and penalty-free CDs with some of the best interest rates.

Different Types of CDs

Many banks offer a few different types of CDs. These CDs each have a specific investment term yet have different initial deposits, redemption penalties, and interest rates.

Term CDs

Most traditional CDs are “term CDs” where you commit to invest your cash for a specific number of months and pay an early redemption penalty. Most CD terms are between three months and sixty months (five years).

CDs with a longer-terms can offer higher yields as a reward for your patience. But, it’s always a good idea to compare the yields of short-term and long-term CDs to find the best option.

Also, compare the CD rate to the best savings account rates. If the rates are similar, you might split your cash into both accounts. Interest rates for savings accounts have been decreasing lately and a term CD can secure a higher interest rate for more months as banks slash rates for savings accounts.

Penalty-Free CD

It’s possible to get a penalty-free CD that lets you make early withdrawals but your interest rate might be lower than a regular CD. For example, CIT Bank has an 11-month no-penalty CD.

Jumbo CD

Jumbo CDs can have the highest interest rates while requiring the largest initial deposit and a longer investment term. Most jumbo CDs require a minimum $100,000 initial deposit and the shortest term may only be 24 months.

Bump-Up CD

Some banks offer “bump-up CDs” or “step-up CDs.” These CDs let you request a one-time interest rate increase during your original CD term. When interest rates rise, a bump-up CD can be an excellent alternative to opening a long-term CD when rates are low.

Brokered CD

Full-service online brokers like Fidelity and Charles Schwab offer brokered CDs to invest your spare cash for a short-term earnings boost. Depending on the broker, this CD type can have additional fees.

IRA CD

Banks offer tax-advantaged traditional and Roth IRA accounts that only hold CDs.

Frequently Asked Questions about CDs

Do CDs Pay Interest Monthly?

Many CDs compound interest daily but either distribute the interest payments monthly or annually. It is common for banks to only distribute your interest once per year or when your CD matures. Capital One 360 is one of the few banks to offer monthly interest payments.

Are CDs Taxable?

The interest income from CDs has the same tax treatment as your savings account and money market account earnings. You will receive an IRS Form 1099-INT listing your taxable income.

One way to avoid paying upfront income taxes on your CD interest is with a CD IRA.

Can You Add Money to a CD?

Banks won’t let you add money to an existing CD. Any new deposit opens a new CD with a new maturity date and interest rate.

Do CDs Automatically Renew?

Most bank CDs automatically renew for the same term and the current interest rate on the renewal date. If you want to redeem your CD, banks offer a 10-day grace period after the CD maturity date to avoid an early withdrawal penalty.

Can You Lose Money in a CD?

CDs can’t decrease in value. They are covered under FDIC insurance like a savings account. If the bank fails, you can recoup up to the first $250,000 of your CD investments — so the only way to lose money on a CD is if you have more than $250,000 in the bank and the bank fails. 

However, there is an opportunity risk. As even the best CD rates are below the annual inflation rate, you’re technically losing money. (Your money will buy less year over year since “stuff” is getting more expensive all the time.) But earning some interest can be better than nothing. Plus, it’s not wise to keep all of your cash in the stock market and alternative investments.

Early Redemption Penalties

Most investors lose money with CDs because of early redemption penalties.

So, you should only invest the amount of cash that you don’t anticipate using until the CD matures. Once the CD term ends, you can redeem your initial deposit and interest earnings.

The early redemption penalty depends on the CD term length:

  • CD term of 12 months or less: 3 months of interest
  • Term between 12 months and 36 months: 6 months of interest
  • Terms longer than 36 months: 12 months of interest

Most banks adhere to this early redemption penalty schedule. If you don’t have enough interest income to cover the fee, the bank withholds part of your original deposit.

Are CDs a Good Investment?

CDs can be a great alternative to a high yield savings account or money market account. As bank interest rates fluctuate regularly, a CD secures a current interest for a specific number of months.

Locking in an interest rate lets you calculate your fixed-income earnings. You can also avoid the negative impact on your investment rate of return from interest rate drops.

When to Avoid CDs

CDs are not a good investment if you need instant access to your cash. You’ll lose some or all of the interest you’ve earned if you withdraw from the CD before maturity. 

On the other extreme, if you know you won’t need access to the money for several years then stocks and other investments might be a better choice. While they are riskier, they also have a higher income potential for long-term investments.

Who Should Open a CD?

You might consider opening a CD in these instances:

  • Earn passive income with a fixed interest rate
  • Hedge against falling interest rates for savings accounts
  • Want to avoid the inherent market risk of stocks and bonds
  • Want a low-risk investment option

How to Open a CD Account

The process for opening a CD is similar at any bank. Below is a step-by-step process of what it looks like to open a CD.

  1. Choose a bank offering CDs – here are the best rates
  2. Compare CD term lengths and interest rates
  3. Make the opening deposit
  4. Let your money sit and earn compound interest
  5. Withdraw your balance when the CD matures – or let it automatically renew

If the bank offers traditional CDs and no-penalty CDs, compare the interest rates. Earning a lower rate can be worth it if you anticipate a better investment opportunity coming along before the CD matures.

Build a CD Ladder

It’s difficult to predict if CD interest rates will increase or decrease in the coming months or years. Building a CD ladder is a popular way to diversify your interest rates and maturity rates.

You can start by opening CDs with different maturity dates. If you don’t need the cash, you let the CD automatically renew for the best available interest rate for that CD term.

Here’s how to build a CD ladder.

Alternatives to Bank CDs

Bank CDs are a good option for earning passive income with a fixed interest rate when most cash investments have variable yields. As you most likely don’t want to put all of your cash into CDs, these alternatives also earn interest and can offer instant redemptions.

High Yield Savings Account

A high yield savings account offers competitive yields to CDs and you can make up to six fee-free withdrawals per statement cycle. The best online banks don’t have a minimum initial deposit or account fees. One downside of savings accounts is that banks can raise or cut interest rates without notice.

Check out our list of the best High Yield Savings Accounts.

Money Market Account

Similar to a high yield savings account, a money market account can offer high-interest rates. Money market accounts provide some checking account-type perks including online bill pay and a debit card. Like high yield savings accounts, you can make up to six withdrawals each month.

Check out our list of the best Money Market Accounts

Cash Management Account

A cash management account is a hybrid between a high-interest savings account and a checking account. Most accounts pay a competitive interest rate and you can make unlimited monthly withdrawals.

As robo-advisors and investing apps are most likely to offer this account type, your deposits are SIPC-insured instead of FDIC-insured. You might consider this option if you want to earn interest on uninvested cash sitting in your investment account.

Small Business Bonds

In addition to the corporate and government bond ETFs in your brokerage account, you might buy collateral-backed small business bonds. Worthy Bonds currently have a 5% annual return with a $10 investment minimum. Each bond has a 36-month term but there are no early withdrawal penalties.

Dividend Stocks

If you have some risk appetite, dividend stocks can produce a higher annual yield. If the share price increases, you can capture extra gains when you sell shares. Your investment growth is more likely to outpace inflation too.

Summary

Knowing the investment term and withdrawal rules are vital to understanding how CDs work. Once you decide how long you’re willing to invest your money, you can find the best interest rates and earn more interest than a savings account.

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About Josh Patoka

After graduating in $50k with student loans in May 2008 from Virginia Military Institute with a B.A. International Studies and Political Science with a minor in Spanish (I studied abroad in Sevilla, Spain for 3 months), Josh decided to sell his soul for seven years by working in the transportation industry to get out of debt ASAP and focus on doing something else with a better work-life balance.

He is a father of three and has been writing about (almost) everything personal finance since 2015. You can also find him at his own blog Money Buffalo where he shares his personal experience of becoming debt-free (twice) and taking a 50%+ pay cut when he changed careers.

Today, Josh relishes the flexibility of being self-employed and debt-free and encourages others to pursue their dreams. Josh enjoys spending his free time reading books and spending time with his wife and three children.

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