How do CDs work?
When you invest in a CD, you place your money in the account for a set period of time — from as little as 7 days up to five years or more. During that time, your money accrues interest typically at a fixed rate. The interest in generally paid back into the account at regular intervals, where it will then compound (though other deposit options may be available).
When the CD matures, you have several options. You can:
- Roll it over into a similar CD at the same bank. (With some CDs, this may happen automatically if you don't withdraw the money within a certain time frame after maturity.)
- Transfer it into another account at that bank.
- Set up another CD at a different bank with different terms.
- Withdraw the money, plus interest earned.
Some investors optimize the CDs' fixed rates and term lengths by setting up a CD ladder.1 These structures ensure that different CDs come due at different times, enabling investors to take advantage of rising interest rates or receive regular payments from maturing accounts.
What are the benefits of CDs?
CDs combine better returns than traditional savings accounts with the safety of FDIC insurance2. With a CD, your savings builds interest, generally at a higher rate3 than standard savings accounts. Although money in a CD will often not grow as quickly as investments in stocks and other securities, CDs opened through a bank are protected by FDIC insurance up to $250,000 per depositer.
This savings vehicle can make sense if your money is earmarked for something specific at a later date. For example, you might want to set aside your tax refund for a down payment on a house. If you take out a CD that matures when you are ready to buy, you'll be assured of having the money, plus interest.
When are CDs not the right choice?
Because you typically pay a penalty if you withdraw funds from a CD before the maturity date, CDs are not the best option if you need more liquidity. Also, CD rates sometimes do not outpace inflation, which means your effective spending power could be lower after the maturity date. Finally, if interest rates rise while you're locked into a CD, you risk missing out on a higher rate.
What should you know before setting up a CD?
If you are considering a CD, check the available offerings at your bank and be sure you fully understand the terms. Questions to get answers to include:
- What is the term of the CD? When will the CD mature?
- Is there a penalty for early withdrawal?
- What is the interest rate?
- Is the interest rate fixed or variable?
- If the interest rate is variable, what is the rate tied to?
- Is the CD FDIC-insured?
- Does the CD automatically renew? And if you miss the renewal date, what is the window of time after maturity during which you can withdraw without incurring an early withdrawal penalty?