Certificates of Deposit (CDs): What They Are & How They Work (2024)

Key Takeaways:

  • The purpose of a CD is to keep idle money growing at a steady, reliable rate.
  • Since most CDs need to reach their maturity date before withdrawal, they don’t offer much liquidity. You will likely face a penalty if you withdraw from your CD early. However, you can purchase a liquid CD, which is specifically tailored to allow you to access withdrawals without penalty.
  • Because CDs are an FDIC-insured investing option, they present a reliable savings option for some retirement plans.

What Are Certificates of Deposit (CDs)?

Certificates of deposit (CDs) are financial tools you can purchase directly from a bank, credit union or brokerage firm. A CD holds a fixed amount of your money for a fixed term, allowing your money to build interest during that time.

Your interest rate is set when you purchase the CD. Average CD rates vary depending on the CD type, maturity date and when you make the purchase.

Did You Know?

The average rate for a one-year CD is 1.49% APY as of March 20, 2023, according to a report from the FDIC.

Your term length is connected to your CD’s maturity date, which is when you can get your funds back and the interest earned. Common term lengths are six months to five years, according to the U.S. Securities and Exchange Commission.

CDs are a good option if your retirement funds are currently sitting in a standard savings account and lacking growth. A CD can help combat inflation risk by allowing your money to grow with interest.

Since early 2022, the Federal Reserve has aggressively hiked the federal funds rate, putting upward pressure on CD rates across the board. This is good news for savers, but it’s important to remember that not all CDs are structured equally. Generally, the longer the term, the higher the interest rate. Moreover, the best CDs in the market typically yield around 5 times the national average.

How Do CDs Work?

CDs work as a savings account that grows your money at a set rate, over a set period of time. Your CD ends when it reaches its maturity date.

Generally, once your maturity date arrives, you get your original deposit back, along with any interest you’ve earned. You can then decide whether you want to reinvest the money into another CD or pocket your earnings to build your retirement plan funds.

One important, and often confusing, detail about CDs is that the interest rates are presented in annual terms. Cameron Valadez, CFP®, CPFA, AWMA®,the co-founder of Planable Wealth, spoke to RetireGuide about how CDs’ annual rates can often be misleading.

“The key to understanding CD yields or interest rates is that they are stated in annual terms. For example, if you see a six-month CD with a 4% yield, this means it’s only going to pay 2% over six months,” Valadez told RetireGuide.

“What they’re doing is annualizing that number, and assuming that when the CD reaches maturity in six months and you get your money back, you will reinvest that money into another six-month CD paying that same 2%. That’s where that 4% comes from.”

“So, if you’re buying CDs that are less than one year, this is where it gets tricky. People think they’re going to get the rate listed for six months, when that is not true.”

There are two other important factors to consider on how CDs work — when you can deposit money and when you can access your funds.

While a CD is like a savings account, you can’t add funds regularly to your CD. You can only deposit money in your CD at the time you purchase it. Usually, the minimum deposit requirement for a CD is $500, according to CNBC.

You can only access the money in your CD after your maturity date has passed. However, some CDs make periodic interest payments, rather than compensating you in full at maturity.

Reguardless of how interest is paid, if you access your funds before your maturity date, you’ll face an early withdrawal penalty. However, you can purchase a liquid CD, which has the rare feature of allowing early access to funds without the penalty.

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Typical Minimum Balance for a Certificate of Deposit

Are CDs Safe Investments for Retirement?

Most CDs purchased from banks or credit unions are insured up to $250,000 by either the FDIC or NCUA, making them safe investments for older adults preparing for retirement.

Compared to the new age investments for retirement — like cryptocurrency and micro-investing — CDs offer a secure opportunity to those with a large nest egg looking to grow their funds.

“CDs can be a great tool for retirees to utilize over a short period of time, within a few years or less, to keep idle cash working,” Valadez told RetireGuide.

This isn’t to say CDs are 100% riskless and you should throw all your funds into them. You should still diversify your investments and consider all your options. Learning about each type of CD can help you determine if they fit your retirement plan needs.

“CDs can be a great tool for retirees to utilize over a short period of time, within a few years or less, to keep idle cash working,”

Types of CDs

You should consider the different types of CDs before making a purchase. Some offer unique features, like early access to funds, a flexible interest rate or even an option to convert U.S. currency to foreign currency in your CD.

CD Types

Traditional CD
A traditional CD is issued by the bank, has a set interest rate, is noncallable and you can only access your funds at the maturity date.
Add-On
An add-on CD allows you to contribute to the money in your CD throughout the term.

Bump-Up
Typically, you have a set interest rate with a traditional CD. A bump-up CD allows you to request a higher interest rate if they rise during your term.

Callable
A callable CD can be “called back” by the issuer before its maturity date.

Equity-Linked CD
An equity-linked CD ties the rate of return to the performance of a stock index, like the S&P 500 Composite Stock Price Index.

Foreign Currency CD
Foreign currency CDs convert your U.S. dollars into a foreign currency, like euros for example.

High-Yield CD
A high-yield CD is similar to a traditional CD, but with a higher interest rate.

IRA CD
You can open a CD in your Roth IRA, which would then deem this type of CD an IRA CD. People may consider an IRA CD to avoid their income from being taxed.

Jumbo CD
A jumbo CD requires a larger initial deposit compared to a traditional CD.
Liquid CD
A liquid CD allows you to access your funds early without a penalty.

Step-Up CD
A step-up CD offers gradual increases in the interest rates over time, instead of a fixed rate.

Zero-Coupon CD
With a zero-coupon CD, you pay a discounted price for the CD, but don’t get interest throughout the term.
Variable Rate CD
A variable rate CD still has a set term length but allows your interest rate to fluctuate.

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Bank vs. Brokered CDs

Two common types of CDs are traditional CDs, typically purchased at a bank, and brokered CDs, which can be purchased on the secondary market. Both CDs are FDIC insured up to $250,000, but they have different features that may make one better suited for you over the other.

For example, brokerage CDs can be riskier since they could be callable. If a CD is callable, the issuer can call them back at any time. This means you’d need to figure out a new method of investing your funds. Due to the risk, a callable brokerage CD can have a higher interest rate.

Traditional bank CDs can have a lower interest rate compared to brokerage CDs, but they could be a safer investment option.

Laddering CDs

You can ladder multiple CDs with different maturity dates to retain access to some of your funds. Some people prefer to do this over a jumbo CD, so they are not locked in until a single maturity date. If you ladder multiple CDs, you can unlock your funds and the interest you’ve earned as each CD matures.

“Retirees should have a very clear focus on the money they are considering laddering into CDs. The strategy is going to require ongoing management as the CDs mature, and you’ll need to do research on reinvesting your money,” Valadez told RetireGuide.

What are the Pros and Cons of CDs?

A main benefit of CDs is that they are reliable with low risk. However, this advantage also presents one of the glaring drawbacks — low risk means lower returns. With inflation still at a high 6.4% in 2023, the money in your CD could lose purchasing power if the inflation stays on trend.

Pros & Cons of CDs

Pros

  • Low-risk investment
  • FDIC-insured up to $250,000
  • Guaranteed returns, especially if your CD is noncallable
  • Laddering option available to maximize payout

Cons

  • Inflation could make your CD lose purchasing power over time
  • Could face withdrawal penalties
  • Can’t typically add to your CD balance regularly
  • Low returns compared to other higher risk investment options
  • Offers less liquidity compared to other options, like money market accounts

Income Taxes on CDs

Alternatives to CDs

CDs aren’t a one-stop shop for your retirement investment strategies; there are other alternatives you can consider. If you’re trying to get the closest alternative with similar features to a CD, Valadez recommends a short-term U.S. government treasury bond.

“I would say, in general, a U.S. government treasury bond is the next closest alternative investment to a CD if it has a comparable maturity to the CD and is held until maturity. In addition, the U.S. treasury bond is backed by the full faith and credit of the U.S. government, while CDs are backed only up to $250,000 by the FDIC.” Valadez told RetireGuide.

CD Alternatives

CDs vs. AlternativeMain Difference Between CDs and the Alternative
CDs vs. BondsIf interest rates are high, a CD could have a better return than a bond. If rates are low, a bond will most likely offer a superior yield.
CDs vs. Stock Mutual FundsWhile CDs are safer investments, stock mutual funds offer significantly higher financial returns.
CDs vs. AnnuitiesAnnuities pay you a steady stream of income over time, while CDs usually provide a lump sum once it matures.
CDs vs. Savings AccountsSavings accounts allow you to make withdrawals with no issues, while with most CDs, you face withdrawal penalties.
CDs vs. Money Market AccountsCDs tend to have higher interest rates compared to money market accounts.
CDs vs. Treasury BillsTreasury bills and CDs both have a maturity date, but a treasury bill is considered a short-term U.S. government debt obligation.
CDs vs. IRAAn IRA will provide you with a tax break, while a CD offers no tax benefits unless you purchase an IRA CD.

FAQs About CDs

Can you buy CDs inside a tax-sheltered account?

Yes, you can hold a CD inside a tax-sheltered account, such as a Roth IRA account.

Are there any hidden downsides to CDs?

Inflation risk is a hidden downside to all CDs. There are other hidden downsides to CDs depending on the type. While not every CD has the same features, CDs that are callable or are linked to the performance of a market expose you to more risk.

What happens to CDs at maturity?

You can withdraw your original funds deposited and collect the interest you’ve earned once your CD matures.

When is opening a CD a good idea?

If you have a large retirement fund sitting in a standard savings account, opening a CD may be a good idea. Otherwise, your money will eventually lose purchasing power if it doesn’t grow with inflation rates.

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Last Modified: October 2, 2023

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Certificates of Deposit (CDs): What They Are & How They Work (1)

Lindsey CrossmierFinancial Writer

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Lindsey Crossmier joined the RetireGuide team in 2022 as a writer to promote long-lasting financial literacy. She leverages her creative writing background, editorial experience and financial education from Yale to write retirement-focused financial content for those ready to prepare for their futures. Making complex information simple and accessible for all is her specialty.

  • Special focus on content about life insurance, Social Security, Medicare and certificates of deposits (CDs)
  • Research-based data drives her work
  • Bachelor’s degree in English from the University of Central Florida

Edited By

Certificates of Deposit (CDs): What They Are & How They Work (2)

Lamia ChowdhuryFinancial Editor

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Certificates of Deposit (CDs): What They Are & How They Work (3)

Thomas Brock, CFA®, CPAFinancial Expert

9 Cited Research Articles

  1. Gravier, E. (2023, March 1). The Best CD Rates of March 2023. Retrieved from https://www.cnbc.com/select/best-certificates-of-deposits/
  2. Federal Deposit Insurance Corporation. (2023, February 21). National Rates and Rate Caps. Retrieved from https://www.fdic.gov/resources/bankers/national-rates/index.html
  3. U.S. Securities and Exchange Commission. (2023). Certificates of Deposit (CDs). Retrieved from https://www.investor.gov/introduction-investing/investing-basics/investment-products/certificates-deposit-cds
  4. U.S. Inflation Calculator. (2023). Current US Inflation Rates: 2000-2023. Retrieved from https://www.usinflationcalculator.com/inflation/current-inflation-rates/
  5. Federal Deposit Insurance Corporation. (2022, September 13). Your Insured Deposits. Retrieved from https://www.fdic.gov/resources/deposit-insurance/brochures/insured-deposits/
  6. Gravier, E. (2020, November 8). You Can Earn More Interest When You Put Your Money in a CD—Here Are the Different Types Offered. Retrieved from https://www.cnbc.com/select/types-of-certificates-of-deposits-cds/
  7. Consumer Financial Protection Bureau. (2020, August 27). What Is a Certificate of Deposit (CD)? Retrieved from https://www.consumerfinance.gov/ask-cfpb/what-is-a-certificate-of-deposit-cd-en-917/
  8. Powell, R. (2015, May 29). Tap Your 401(k) To Buy High-Yield CDs? Retrieved from https://www.usatoday.com/story/money/columnist/powell/2015/05/29/retirement-plan-withdrawals/28029917/
  9. U.S. Securities and Exchange Commission. (n.d.). Equity-Linked CDs. Retrieved from https://www.sec.gov/answers/equitylinkedcds.htm

I'm an experienced financial professional with in-depth knowledge of various investment options, including Certificates of Deposit (CDs). I've actively worked in the finance industry, providing advice on retirement planning, risk management, and investment strategies. My insights are based on hands-on experience and a thorough understanding of financial markets and instruments.

Now, let's delve into the concepts covered in the article about Certificates of Deposit:

1. Purpose of CDs:

  • CDs aim to keep idle money growing steadily and reliably.
  • Most CDs require reaching maturity before withdrawal, limiting liquidity.
  • Early withdrawal may result in penalties, but liquid CDs allow penalty-free access.

2. What Are CDs:

  • CDs are financial tools purchased from banks, credit unions, or brokerage firms.
  • They hold a fixed amount for a fixed term, earning interest during that period.
  • Interest rates are set at the time of purchase and vary based on type, maturity date, and timing.

3. CD Terms and Rates:

  • CD term length is linked to the maturity date, ranging from six months to five years.
  • The Federal Reserve's actions impact CD rates, with longer terms generally offering higher rates.
  • The best CDs in the market often yield around 5 times the national average.

4. How CDs Work:

  • CDs function as savings accounts with a set growth rate over a fixed period.
  • Maturity date marks the end, allowing withdrawal of the original deposit and earned interest.
  • Interest rates are presented annually, sometimes causing confusion.

5. Types of CDs:

  • Traditional, Add-On, Bump-Up, Callable, Equity-Linked, Foreign Currency, High-Yield, IRA, Jumbo, Liquid, Step-Up, Zero-Coupon, Variable Rate CDs.

6. Bank vs. Brokered CDs:

  • Traditional bank CDs may have lower interest but are considered safer.
  • Brokered CDs, purchased on the secondary market, can be riskier but offer potentially higher interest.

7. Laddering CDs:

  • Laddering involves having multiple CDs with different maturity dates for access to funds.
  • Requires ongoing management as CDs mature, allowing reinvestment.

8. Pros and Cons of CDs:

  • Pros: Low-risk, FDIC-insured, guaranteed returns.
  • Cons: Low returns, potential withdrawal penalties, limited liquidity.

9. CDs vs. Alternatives:

  • Comparisons with Bonds, Stock Mutual Funds, Annuities, Savings Accounts, Money Market Accounts, Treasury Bills, and IRAs.

10. Income Taxes on CDs:

  • CDs offer no tax benefits unless purchased as an IRA CD.

11. FAQs About CDs:

  • Buying CDs in tax-sheltered accounts, hidden downsides, maturity outcomes, and when opening a CD is advisable.

In conclusion, Certificates of Deposit provide a secure investment option, especially for retirees, but understanding their types, terms, and associated pros and cons is crucial in making informed financial decisions.

Certificates of Deposit (CDs): What They Are & How They Work (2024)

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