A CD is a savings account where you agree to leave money untouched for a set time in exchange for a fixed interest rate

A certificate of deposit (CD) is a contract between you and a bank. You give the bank a sum of money — say $1,000 or $5,000 — and promise not to touch it for a specific period, called the term. In return, the bank pays you a fixed interest rate, usually higher than a regular savings account offers. When the term ends, you get your original money back plus the interest earned.

The bank uses your money during that time, which is why they pay you more interest than they would if you could withdraw whenever you wanted. You are essentially lending the bank your money for a may provide return. The tradeoff is that your money is locked away — if you need it before the term ends, you typically pay a penalty.

CDs come in different term lengths: 3 months, 6 months, 1 year, 2 years, 5 years, and sometimes longer. The longer the term, the higher the interest rate usually is, because the bank has your money for a longer period.

Key Takeaways

  • You deposit a fixed amount of money and agree not to withdraw it until the term ends, in exchange for a may provide interest rate.
  • The interest rate on a CD is set when you open it and does not change, even if bank rates rise or fall during your term.
  • If you withdraw money before the term ends, you pay an early withdrawal penalty, which reduces your earnings or your principal.
  • When your CD matures (the term ends), you can withdraw your money, open a new CD, or let it automatically renew at the bank's current rate.
  • CDs are insured by the FDIC up to $250,000 per depositor per bank, so your money is protected even if the bank fails.

How interest accrues and compounds on a CD

The interest rate you receive is expressed as an annual percentage rate, or APY. This is the actual return you will earn in one year, including the effect of compounding — when interest is added to your balance and then earns interest itself.

For example, if you deposit $1,000 in a 1-year CD with a 4.5% APY, you will earn $45 in interest over the year. The bank may add that interest monthly, quarterly, or at maturity, depending on the CD. If interest compounds monthly, you earn a small amount of interest each month, and the next month's interest is calculated on the new, slightly higher balance. By the end of the year, you will have slightly more than $1,045 because of compounding.

The longer your term and the higher your APY, the more interest you earn. A $5,000 CD at 5% APY for 2 years will earn roughly $512.50 (accounting for compounding), while the same amount at 3% APY for 1 year earns about $150.

What happens if you need your money before the term ends

Most banks charge an early withdrawal penalty if you take money out before your CD matures. The penalty is usually expressed as a number of months of interest — for example, "three months of interest" or "six months of interest." Some banks use a percentage of your principal instead.

If you withdraw early, the bank subtracts the penalty from your earnings. If the penalty is larger than the interest you have earned so far, you lose part of your original deposit. For a $1,000 CD earning 4% APY with a six-month penalty, withdrawing after three months might cost you $20 in interest plus a $20 penalty, leaving you with $960.

Before opening a CD, read the disclosure document to see what the early withdrawal penalty is. Some banks offer "no-penalty CDs" with lower interest rates but no penalty if you need the money early. These are worth considering if you are not certain you can leave the money untouched.

What maturity means and what happens next

When your CD term ends, the CD matures. At that point, you have several choices. You can withdraw the full amount (principal plus interest) with no penalty. You can open a new CD at the bank's current rates. Or you can do nothing, and many banks will automatically renew your CD into a new term at their current rate.

Automatic renewal is convenient but not always the best choice. If interest rates have dropped since you opened your original CD, the new rate will be lower. If rates have risen, you may want to shop around at other banks before renewing. Banks are required to give you a grace period — usually 7 to 10 days after maturity — during which you can withdraw your money without penalty, even if the CD has already renewed.

Mark your calendar for the maturity date so you do not miss the grace period. If you want to move your money elsewhere, contact the bank before the grace period ends.

How CD rates are set and why they change

Banks set CD rates based on what the Federal Reserve does with interest rates. When the Fed raises its benchmark rate, banks typically raise CD rates to attract deposits. When the Fed lowers rates, CD rates fall. Market conditions and competition between banks also affect rates — a bank trying to attract more deposits might offer higher rates than its competitors.

The rate you lock in when you open your CD stays the same for the entire term, no matter what happens to the market. This is both a benefit and a risk. If rates rise after you open your CD, you are stuck with your lower rate. If rates fall, you benefit from having locked in a higher rate. This is why some people open CDs of different lengths — a "CD ladder" — so that portions of their money mature at different times and can be reinvested at new rates.

FDIC insurance protects your CD deposit

CDs held at banks insured by the FDIC (Federal Deposit Insurance Corporation) are protected up to $250,000 per depositor per bank. This means if the bank fails, the FDIC will return your money up to that limit, even if the bank cannot pay it back.

If you have more than $250,000 to deposit, you can open CDs at multiple banks to stay within the insurance limit at each one. CDs at credit unions are insured similarly by the NCUA (National Credit Union Administration) up to $250,000 per account owner per institution.

This insurance applies whether your CD is in a regular savings account or held in a retirement account like an IRA. The protection covers your principal and any interest earned.

Comparing CDs to other savings options

A regular savings account offers flexibility — you can withdraw money anytime without penalty — but the interest rate is usually much lower than a CD and can change at any time. A money market account sits between the two: higher interest than savings but lower than CDs, with limited withdrawal rights.

CDs make sense if you have money you know you will not need for a specific period and want a may provide return. They do not make sense if you might need the money soon, because the early withdrawal penalty will eat into your earnings. They also do not protect you from inflation — if inflation is 3% and your CD earns 2%, your money is losing purchasing power, even though the balance is growing.

Before choosing a CD, compare rates across banks. Online banks often offer higher rates than brick-and-mortar banks because they have lower overhead costs. Use a rate comparison tool or call banks directly to see current offers.

Frequently Asked Questions

Can I add more money to my CD after I open it?

No. A CD is a fixed contract — you deposit a set amount at the start, and that amount stays the same until maturity. If you want to save more, you would need to open a separate CD or use a regular savings account.

What is the difference between a CD and a savings account?

A savings account lets you withdraw money anytime, but the interest rate is usually lower and can change. A CD locks your money for a set term in exchange for a higher, fixed rate. Savings accounts are better for emergency funds; CDs are better for money you will not need soon.

Do I have to pay taxes on CD interest?

Yes. CD interest is taxable income in the year it is earned or credited to your account, depending on how the bank handles it. The bank will send you a 1099-INT form at tax time showing how much interest you earned. If your CD is in a retirement account like a traditional IRA, taxes are deferred until you withdraw from the IRA.

What happens if I die before my CD matures?

Your CD becomes part of your estate and passes to your heirs or beneficiary. They can withdraw the money without penalty, even if the term has not ended. Make sure your bank has your beneficiary information on file so the process is smoother for your family.

Is there a minimum amount I have to deposit in a CD?

Yes, but it varies by bank. Some banks require a minimum of $500 or $1,000, while others may require $5,000 or more. Online banks often have lower minimums than traditional banks. Check with your bank for their specific requirements.