What is a certificate of deposit and how does it work?

Chances are you’ve heard of savings accounts, but there’s another common savings product you may not be as familiar with: certificates of deposit, or CDs. CDs often offer higher yields than savings accounts, and their rates are fixed, unlike savings account rates, which can fluctuate at any time.

But there’s a trade-off: You’re promising the bank that you won’t have to withdraw the money until a certain date in the future. Read on to learn how CDs work, where to find the best CD rates, and what to look for before you open one.

What is a certificate of deposit?

A certificate of deposit, or CD, is a savings option that pays a fixed interest rate, usually offered by a bank or credit union. You agree to deposit a lump sum, known as the principal, for a specified period of time, known as the term.

You often earn a higher APY with a CD than with a regular savings account. In addition, the risk is lower than with other investments, such as mutual funds.

The downside is that CDs are not as flexible as savings accounts. If you need your money before the term expires (the CD’s maturity date), you often have to pay an early withdrawal penalty equal to a few months’ worth of interest.

The longer the term of your CD, the more interest you generally earn. CDs have terms that start at one month and go up to five or ten years.

How does a CD earn interest?

CDs earn compound interest, which means that you earn interest not only on the principal balance, but also on the interest you have earned so far. Many banks charge daily or monthly compound interest on their CDs.

The compounding frequency and interest rate of the CD are reflected in the annual percentage yield, or APY, which is fixed when you open the CD. Because of their fixed interest rate, it is easy to calculate the return you can earn with a CD.

What different types of CDs are there?

In addition to a traditional CD, where you invest a fixed amount for a set period of time, there are several CDs with special rules and benefits. For example, an IRA CD offers investors tax benefits for their retirement, but carries the risk of an additional IRS penalty for early withdrawals.

Among the many other CD options, a foreign currency CD exchanges your money for another country’s currency until it matures, at which point it is converted back into dollars. A zero-coupon CD avoids APY and instead guarantees a specific value for the CD when it matures. A no-penalty CD also offers more flexibility, allowing you to withdraw your money early without an early withdrawal penalty.

Bump-up CDs allow you to increase APYs one time if interest rates rise, and add-on CDs allow you to invest more money over the life of the CD. Each type has its own rules and requirements, which typically vary by bank and CD term.

What is the best CD run time?

It depends on when you think you need your money.

If you plan on buying a car in a few years, putting your auto fund money into a three-year CD may be a safe bet. But if your vehicle is on its last legs, you shouldn’t invest too much in a CD.

If you are saving for the distant future and don’t need the money for a while, look for the highest CD rate you can find. They usually have a term of five years or longer.

Also, always make sure you have an emergency fund in an easily accessible account.

Are CDs insured?

Most CDs offered by banks are insured up to $250,000 per issuer, per bank for each account category by the Federal Deposit Insurance Corporation. The CD equivalent issued by credit unions, often called stock certificates, is insured for the same amount, but by the National Credit Union Administration. Before opening a CD, check to see if the financial institution is FDIC- or NCUA-insured.

Foreign currency CDs are generally not regulated by the FDIC, nor are some broker-issued CDs.

What is a CD ladder?

A locked APY is good news when rates take a nosedive, but when they rise, you could miss out.

Buying multiple CDs with different maturities, also known as CD laddering, allows you to take advantage of both contingencies. It also ensures that at least some of your money is readily available should an unexpected need arise.

Where can I buy a CD?

You can find a variety of CD options at traditional banks, online banks, and credit unions.

You can also buy CDs through stockbrokers, who buy them from the banks. If you have a mediated CD This secondary market allows you to sell your investment before the expiration date without paying a penalty. You may have to pay a brokerage fee.

Correction: An earlier version of this article was assisted by an AI engine and misstated savings accounts and higher-risk assets. Those points have all been corrected. This version has been substantially updated by a staff author.