What a CD is and why banks offer them

A certificate of deposit is an agreement between you and a bank: you give the bank a sum of money for a set period of time, and the bank pays you interest on that money. The bank uses your money during that time and returns both your original amount and the interest when the term ends.

Banks offer CDs because they need to borrow money from customers to lend to other customers and businesses. A CD is a predictable way for them to do that — they know exactly how much money you're lending them and for how long. In return, they pay you a higher interest rate than you'd earn in a regular savings account, because you're agreeing to leave the money untouched.

The tradeoff is straightforward: you get a better rate, but your money is locked up. If you need it before the term ends, the bank charges you a penalty — usually a portion of the interest you've earned, or sometimes a percentage of your principal.

Key Takeaways

  • You deposit a fixed amount of money for a fixed period (called the term), and the bank pays you a set interest rate for the entire term.
  • The interest rate on a CD is higher than a savings account because you agree not to withdraw the money early.
  • If you withdraw before the term ends, you pay an early withdrawal penalty, which reduces or eliminates your interest earnings.
  • When the term ends, your money and interest are returned to you, and you can then withdraw it, move it, or open a new CD.
  • CDs are insured by the FDIC up to $250,000 per depositor per bank, so your principal is protected even if the bank fails.

How the interest rate and term length work together

When you open a CD, the bank tells you two things: the interest rate (the percentage you'll earn) and the term (how long your money stays locked in). Common terms are 3 months, 6 months, 1 year, 2 years, and 5 years. Some banks offer other lengths.

The longer the term, the higher the interest rate usually is. A 5-year CD typically pays more than a 1-year CD at the same bank, because the bank gets to use your money for longer. The tradeoff is that your money is locked away for a longer time.

The interest rate is fixed, meaning it does not change during the term. If you open a 2-year CD at 4.5%, you'll earn 4.5% for the full 2 years, even if the bank's rates drop to 2% next month. This is different from a savings account, where the rate can change at any time.

What happens when you deposit money into a CD

You walk into the bank (or go online) and tell them you want to open a CD. You choose the amount — the minimum is usually $500 to $2,500, depending on the bank — and the term length. The bank then calculates how much interest you'll earn and shows you the total you'll have when the term ends.

The money comes out of your checking or savings account when ready. The bank moves it into the CD account, and it stays there untouched. You cannot add more money to that CD later — if you want to deposit more, you open a separate CD.

During the term, you receive statements showing your balance and the interest accruing (building up). You do not have to do anything. The interest is automatically added to your CD account.

Early withdrawal and what the penalty actually costs

If you need your money before the term ends, you can withdraw it. But the bank will charge you an early withdrawal penalty. This penalty is usually expressed as a number of months of interest — for example, "3 months of interest" or "6 months of interest."

Here's how it works in practice: suppose you open a 2-year CD with $10,000 at 4% interest. After one year, you need the money. The bank calculates that you've earned about $400 in interest so far. If the penalty is "3 months of interest," the bank subtracts 3 months' worth of interest (about $100) from what you get back. You receive $10,300 instead of $10,400.

Some banks charge a flat dollar amount instead — for example, $50 or $100 — regardless of how much interest you've earned. A few banks charge a percentage of your principal. Always ask what the penalty is before you open the CD, because it varies widely between banks and between different CD terms at the same bank.

If you withdraw very early — say, after 2 months of a 2-year CD — the penalty might be larger than the interest you've earned so far. In that case, you get back less than you deposited. This is why CDs are meant for money you know you won't need.

What happens when the CD term ends

When your term ends, the bank enters a period called the maturity date or grace period, usually lasting 7 to 10 days. During this time, you can do one of three things: withdraw the money, move it to another account, or let the bank automatically renew the CD.

If you do nothing, many banks automatically roll your CD into a new CD with the same term and the current interest rate. This happens without your permission, so if rates have dropped, you might be locked in at a lower rate. Read your CD agreement to see your bank's renewal policy, and mark your calendar for when the term ends so you can make a choice.

If you want to withdraw, you can usually do so without penalty during the grace period. After the grace period ends, if you still haven't withdrawn and the bank has renewed your CD, you're back to being locked in for another full term.

How FDIC insurance protects your CD

Your CD is insured by the FDIC (Federal Deposit Insurance Corporation), a government agency that protects deposits at member banks. This means if the bank fails, the FDIC returns your money up to $250,000 per depositor per bank.

Your principal — the money you deposited — is protected. The interest you've earned is also protected as part of that $250,000 limit. If you have $250,000 in a CD at Bank A and $250,000 in a CD at Bank B, both are fully protected, because the insurance is per bank, not per person.

This protection is automatic. You do not have to register or do anything. As long as you're opening a CD at an FDIC-member bank (which nearly all banks are), your money is covered.

CDs versus savings accounts and money market accounts

A savings account lets you deposit and withdraw money whenever you want, with no penalty. The interest rate is lower than a CD because the bank cannot count on having your money for any set period. The rate can also change at any time.

A money market account is a hybrid. It usually pays more interest than a savings account but less than a CD. You can withdraw money, but there are limits — typically 6 withdrawals per month. The rate can change, just like a savings account.

Choose a CD if you have money you won't need for several months or years and you want the highest rate. Choose a savings account if you might need the money sooner or want flexibility. A money market account works if you want something in between.

Frequently Asked Questions

Can I withdraw money from a CD before it matures?

Yes, but you'll pay an early withdrawal penalty. The penalty is usually a set number of months of interest or a flat dollar amount. It reduces the total you receive. If you withdraw very early, the penalty might be larger than the interest you've earned, so you get back less than you put in.

What's the difference between a CD and a savings account?

A CD locks your money for a set term and pays a higher, fixed interest rate. A savings account lets you withdraw anytime with no penalty, but the rate is lower and can change. Use a CD for money you won't need; use a savings account for money you might need soon.

What happens if I don't withdraw my money when the CD matures?

Most banks automatically renew your CD into a new term at the current interest rate. This happens during a grace period of 7 to 10 days. Check your bank's policy and mark your calendar so you can withdraw or move the money if you prefer not to renew.

Is my money safe in a CD if the bank fails?

Yes. The FDIC insures CDs up to $250,000 per depositor per bank. Your principal and earned interest are both protected. This coverage is automatic at any FDIC-member bank, which includes nearly all banks in the United States.

Do I have to 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 at the end of the year showing how much interest you earned. You report this on your tax return, even if you haven't withdrawn the money yet.