A certificate of deposit is a savings account where you agree to leave money untouched for a set time in exchange for a higher interest rate

A certificate of deposit, or CD, is a contract between you and a bank. You give the bank a lump sum of money—say $1,000 or $5,000—and promise not to touch it for a specific period. That period might be three months, one year, five years, or longer. In return, the bank pays you interest at a rate higher than a regular savings account would offer. When the time is up, you get your original money back plus the interest earned.

The key difference from a regular savings account is the lock-in period. With a savings account, you can withdraw money whenever you want. With a CD, if you take your money out before the agreed time ends, the bank charges you a penalty—usually a loss of some or all of the interest you earned, or sometimes a small fee. That penalty is how the bank protects itself: it counts on your money staying put so it can lend that money out and make its own profit.

CDs are considered very safe. Your money is insured by the FDIC (Federal Deposit Insurance Corporation) up to $250,000 per account, per bank. This means if the bank fails, the government guarantees you get your money back. Because CDs are safe and the bank knows exactly how long it will have your money, the interest rate is usually better than what you'd earn in a savings account—though it's typically lower than what you might earn by investing in stocks or bonds.

Key Takeaways

  • You deposit a fixed amount of money for a fixed time period, and the bank pays you a set interest rate that is usually higher than a savings account.
  • If you withdraw the money before the time period ends, you pay a penalty, typically a loss of interest or a small fee.
  • CDs are insured by the FDIC up to $250,000, making them one of the safest places to keep money in a bank.
  • The longer you agree to lock your money away, the higher the interest rate the bank usually offers.
  • CDs work best for money you know you won't need soon and want to grow slowly with no risk.

How the interest rate and time period work together

Banks offer different rates for different time periods. A three-month CD might pay 4% annual interest, while a five-year CD might pay 5% annual interest. The longer you lock your money away, the higher the rate usually is, because the bank gets to use your money for longer and can count on it being there.

The interest rate is fixed, meaning it does not change. If you buy a one-year CD at 4.5%, you will earn 4.5% no matter what happens to interest rates in the economy during that year. This is different from a savings account, where the bank can lower the rate whenever it wants. The trade-off is that if interest rates rise, you are stuck with your lower rate until the CD matures.

Interest on a CD compounds, usually monthly or daily depending on the bank. This means you earn interest on your interest. If you have $1,000 in a CD earning 5% annual interest compounded monthly, after one month you have $1,004.17. The next month, you earn interest on $1,004.17, not just the original $1,000. Over a full year, this compounds to about $51.16 in total interest, not exactly $50.

What happens when your CD reaches maturity

When the time period ends—when the CD matures—the bank notifies you. You then have a choice window, usually five to ten days. You can withdraw the money and interest, or you can renew the CD, which means rolling the money into a new CD at whatever the current interest rate is.

If you do nothing during that window, many banks automatically renew your CD into a new one at the current rate. This can work in your favor if rates have risen, but it locks your money away again. Read the terms carefully so you know what your bank does automatically. Some banks will move the money to a regular savings account instead if you do not act.

If you withdraw the money, it goes into your checking or savings account at the bank, or the bank can send you a check. There is no penalty for withdrawing after maturity—the penalty only applies if you withdraw early.

The penalty for early withdrawal

If you need your money before the CD matures, you can withdraw it, but you will pay a cost. The penalty varies by bank and by the length of the CD. A common penalty for a one-year CD might be three months of interest. For a five-year CD, it might be one year of interest. Some banks charge a flat fee instead, like $25 or $50.

Before you open a CD, ask the bank what the early withdrawal penalty is. Write it down. If you think there is any chance you might need the money, factor that penalty into your decision. For example, if a one-year CD pays $50 in interest but the penalty is $40, you would only net $10 if you withdrew after six months. In that case, a regular savings account might have been the better choice.

When a CD makes sense for your situation

CDs work best when you have money you know you will not need for a while. If you are saving for a down payment on a house and you plan to buy in two years, a two-year CD is a good fit. If you have an emergency fund that you might need to access quickly, a CD is not the right place for it.

CDs also make sense if you want to lock in a good interest rate. If rates are high right now and you think they might drop later, a longer CD lets you keep that rate. Conversely, if you think rates will rise, a shorter CD lets you reinvest at a higher rate sooner.

Some people use a strategy called a CD ladder. Instead of putting all their money in one CD that matures in five years, they buy five one-year CDs. Each year, one CD matures, and they can either withdraw the money or renew it. This gives them more flexibility and lets them take advantage of rising rates without waiting five years.

CDs versus other savings options

A regular savings account is more flexible than a CD—you can withdraw money anytime without penalty—but it usually pays less interest. A money market account is somewhere in between: it pays more than a savings account but less than a CD, and you can write checks or make withdrawals, though sometimes with limits. A high-yield savings account at an online bank can pay almost as much as a CD and still lets you access your money.

If you are willing to take on risk, stocks and bonds can earn more over time than a CD, but they can also lose value. A CD guarantees you will get your money back plus the interest, no matter what happens in the economy. That safety comes at the cost of lower returns.

Frequently Asked Questions

Can I withdraw money from a CD before it matures?

Yes, but you will pay a penalty. The penalty is usually a loss of some or all of the interest you earned, or sometimes a flat fee. The exact penalty depends on your bank and the length of the CD. Check your CD agreement to see what it is before you open the account.

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

A savings account lets you withdraw money anytime without penalty, but it pays lower interest. A CD locks your money away for a set time and pays higher interest, but charges a penalty if you withdraw early. Both are FDIC insured up to $250,000.

Do I 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 tax time showing how much interest you earned. You report this on your tax return. This is true even if you do not withdraw the money yet—you owe taxes on the interest in the year it was earned.

What happens if the bank fails while I have a CD?

The FDIC insures your CD up to $250,000. If the bank fails, the FDIC pays you your original deposit plus any interest earned up to that date. Your money is safe. This protection applies as long as the bank is FDIC insured, which most banks are.

Can I move a CD to a different bank?

You can withdraw your money from one bank and open a CD at another bank, but you will pay the early withdrawal penalty at the first bank. Some banks offer CD transfers where they pay the penalty for you to move your CD to them, but this is not common. It is worth asking.