What is a CD account & how does it work?

Investments that offer a guaranteed rate of return can help you save toward specific goals while feeling confident about less risk of loss. A certificate of deposit (CD) account, which delivers both predictability and safety, can play an important role in your financial strategy. CDs generally earn a fixed interest rate on a lump-sum deposit for a specific time period.

Here's what you need to know about CDs and why they're so popular among savers.

A certificate of deposit (CD) is a savings account offered by banks and/or credit unions with a fixed interest rate and maturity date, where you agree to leave your deposit for a specified period in exchange for higher interest.

Traditional CDs operate in a straightforward way: You put money into the account for a specified length of time, and at the end of that term, you get your initial deposit back along with its accumulated interest.

Here are some of the favorable qualities of CDs:

• They're available in a variety of time horizons, typically from three months to five years.
• Many can be automatically renewed with updated interest rates.
• If you leave your money in for the term, you won't pay any penalties or fees.
• They're insured to the deposit limits of either the FDIC or NCUA.

CDs are among the safest investments you can hold, and their predetermined terms make them ideal to use strategically to grow your savings.

Interest rates on CDs can be influenced by multiple factors. Financial institutions generally set their CD rates according to the prevailing interest rate, called the federal funds rate, which is set by the Federal Reserve. Competition among these institutions also may influence the interest rate they pay on their CDs.

Generally, the longer the duration of the CD, the higher the interest rate. A three-year CD likely will pay more interest than a three-month CD, for example. You can think of the higher rate as a reward for being willing to keep your money tied up longer in the CD—and running the risk of missing out on more profitable ways to use that money in that period.

Interest begins to accrue when you open the CD. They offer the advantage of earning compound interest, in which your bank or credit union will add the interest you've received to date to your original balance each time interest accrues. Simply put, you earn interest on your interest. The frequency of compounding returns on a CD can range from daily to annually.

You have some options to choose from when investing in a CD based on where and how long you want to have it. It helps to do some comparison shopping and think about how starting a certificate of deposit can help you achieve your short-term goals before committing to a term. Here are some considerations:

Banks, credit unions and other financial institutions offer CDs. Credit unions may call them "share certificates." Financial institutions change their rates fairly frequently as they stay in competition with each other, so it's a good idea to check several places, including online offerings.

Common CD term lengths include:

• 3 months
• 6 months
• 9 months
• 12 months, or 1 year
• 18 months
• 24 months, or 2 years
• 30 months
• 36 months, or 3 years
• 48 months, or 4 years
• 60 months, or 5 years

Pick a term that aligns with your financial goals. For instance, if you've just gotten engaged and are planning on a big wedding, you might want to go with 6 months to 18 months. But for a down payment on a home in a few years, a three-year term may be a good choice. Saving for a dream vacation sometime down the road could match well with a four-or five-year CD.

When shopping for a CD, you'll want to compare similar terms as much as possible. Often, you'll find shorter CD terms have a higher rate than longer-term ones, but that doesn't mean they're the best option for you. Here's what to weigh against your goals for the money:

• Duration (or term)
• Interest rate
• Annual percentage yield (APY)
• Minimum required deposit
• Penalty for withdrawing funds before maturity
• Whether or not the CD automatically renews

APY in particular can be useful. It makes it easier to compare CDs of different lengths, rates and compounding frequencies. That's because APY tells you the rate of return you would get after one year, factoring in compound interest.

Since CD rates are tied to the federal funds rate, which is influenced by economic conditions, it can be helpful to consider some broader implications of buying a CD at a certain time. Locking in a rate with a long-term CD can be beneficial if you think interest rates will fall before your CD's term ends. On the flip side, you'll be disadvantaged if rates rise before the end of the term.

A CD matures when it reaches the end of its term. There are a few steps you can take at that point.

• Renew the CD. Many CDs renew automatically at the same or similar term. However, the new interest rate may be higher or lower. You can't renew a CD before maturity.
• Open a new CD. You can deposit your withdrawn funds into a new CD that has a different term and potentially a different interest rate.
• Cash out. If you don't want to renew, you'll be able to withdraw your principal amount and accumulated interest within a window of time after the term ends.

Another option is to buy multiple CDs at the same time that have different maturity dates. This strategy, called CD laddering, can help maximize your rate of return. It also offers an alternative to keeping a chunk of funds stored away in a single long-term CD. For example, if you have $15,000 to invest in CDs, you may choose to put $5,000 each in a one-year, three-year and five-year CD.

CDs aren't the only choice for savers. Here's how they differ from four popular alternatives: savings accounts, money market accounts, individual retirement accounts (IRAs) and fixed annuities.

CDs generally pay higher interest rates than savings accounts, but savings accounts offer more flexibility. They allow you to access your money fairly regularly without penalty, although withdrawal limits may apply. Also, unlike with CDs, you can make deposits into savings accounts and keep them open indefinitely.

CDs typically pay higher interest rates than money market accounts (MMAs), but there are other differences between a CD and MMA. With MMAs, the interest rate isn't fixed and fluctuates with the market rate. You aren't penalized for making withdrawals from MMAs, although withdrawal limits may apply. Some MMAs even offer checking features like check writing, debit cards and ATM access. In addition, you regularly can put money into an MMA, and you decide when it's time to close the account.

CDs and IRAs are fundamentally different. IRAs are accounts that hold investments like stocks, mutual funds — and even CDs. IRAs are designed to help you save for retirement, so like CDs, you'll face penalties for withdrawing funds before the rules allow. IRAs have tax benefits that CDs don't, however. Traditional IRAs are tax-deferred until you withdraw money in retirement, and Roth IRAs, which are funded with post-tax dollars, offer you tax-free withdrawals in retirement. Unlike CDs, IRAs have annual contribution limits. In 2024 and 2025, you can contribute $7,000 if you're younger than 50 or $8,000 if you're 50 or older.

Fixed annuities can help you create income in retirement and are generally tax-deferred. Another difference between CDs and fixed annuities pertains to withdrawals: Getting a lump sum isn't your only option with fixed annuities. You also can annuitize and receive regular payments for a specified number of years or receive a guaranteed payment for life. Withdrawing funds before the term ends generally comes with a penalty, but some contracts will allow you to take out a certain amount annually before fees apply. As for the interest rate, it's often set for an initial period and may subsequently change, though it won't fall below the guaranteed minimum interest rate in the contract.

CDs are taxed like other accounts and securities that pay interest, which means you pay income tax on the interest you earn on the CD. The interest is taxable in the year it's paid, and if you've earned more than $10 in interest that year, your bank or credit union should provide you with a 1099-INT statement.

Yes, the interest still is considered to be taxable income even if your CD has not yet matured.

The interest is taxed at the same rate as your ordinary income, like your salary or wages.

If you hold a CD inside a tax-deferred account like an IRA or 401(k), you usually will only pay taxes when you take distributions from the account.

While CDs offer multiple advantages, they're not ideal for everyone. Here are some key elements to consider:

Pros

• A CD earns a fixed amount of interest, so returns are predictable.
• CDs generally pay higher interest rates than savings accounts and MMAs.
• CDs are FDIC- and NCUA-insured.
• With terms typically ranging from three months to five years, you can find a CD that aligns with your short-term savings goals.

Cons

• You may owe a penalty if you withdraw funds from a CD before it matures.
• Even a high-interest CD account may generate smaller returns than money held in stocks or mutual funds if the market increases during the term.
• Your interest rate is locked in, so if rates rise during the term, you could miss out on opportunities to optimize your savings.

You can use a CD to make a lump sum grow bigger over a specific time period. They're helpful for saving for something like a vacation or large purchase or just to earn more on excess cash. Additionally, you can use a CD to save some money for retirement that isn't exposed to the stock market.

Minimum amounts are based on individual banks or credit unions. Some have no minimum deposit, while others may require $500, $1,000 or more.

How much will my CD earn in a year?

There are a few variables to consider, but say you make an initial deposit of $500 into a one-year CD that has a 4% rate and compounds monthly. At maturity, your money will have grown to $610.50. If you make a $10,000 initial investment, it will have grown to $10,407.42 (To use different variables, use this calculator.)

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Investing in a very short-term CD can be a good way to grow money that you don't need now but may need soon. It also can be a safe method of growing a portion of your emergency savings.

No, there are other varieties that work differently, including bump-up CDs and no-penalty CDs. Bump-up CDs allow you to request a one-time bump to a higher rate for the rest of your CD's term if rates increase. No-penalty CDs allow you to withdraw funds early and penalty-free but typically have lower interest rates.