How CD Accounts Work: Secure Savings With Fixed Interest

Understanding CD Accounts: Functionality and Benefits

A certificate of deposit (CD) is an account that pays a specific rate of interest for a set period of time, from a few months to years. CDs usually pay higher interest rates than typical savings accounts. If you have to take money out of your CD before it matures, you will generally be subject to early withdrawal penalties.

CDs are considered to be a safe investment and a good place to put money aside until you need it, while earning interest in the meantime. CDs can vary widely from one financial institution to another in their interest rates and other features.

Discover more about how CDs work, the secure savings they offer with fixed interest rates, their terms, early withdrawal penalties, and how they compare to other accounts.

Important Considerations Before Opening a CD Account

A certificate of deposit is a relatively simple investment product, and buying one is a straightforward process. Here are the key steps for buying a CD:

Step 1. Determine Your Investment Amount

First, you should determine how much money you can invest in a CD. This is important because CDs are not very liquid—that is, you can't get your money out easily if you need it in an emergency. Because of this, you should only put money into a CD if you are fairly sure you aren't going to need it before the CD matures. CDs have early withdrawal penalties (more on that below), which makes them a bad choice for emergency savings or other money you might want at a moment's notice.

Step 2. Choose the Right Type of CD

Many banks and credit unions in the United States offer at least one certificate of deposit, and many have a wide array of them. You'll find CDs offered by nearby brick-and-mortar banks, as well as from regional and national banks that accept customers online. Investopedia's regularly updated ranking of the best CD rates, for example, tracks over 200 financial institutions that offer CDs.

There are three main considerations when choosing a CD:

• The first is the term, or how long you are willing to leave your money in the CD before you can withdraw it. CD terms range from a few months to years. If you aren't sure when you're likely to need your money back, it's better to err on the side of caution. You can always choose a CD with a short term and then reinvest the money in another CD after it matures.
• Interest rates are another consideration. Longer terms generally mean higher rates. But the range of CD rates can vary widely from one financial institution to another. The top-paying CDs in the country may pay many times the national average rate, so it's smart to shop around.
• Finally, consider whether a standard or specialized type of CD would be best for you. Standard CDs pay a set interest rate and charge penalties for early withdrawals. Other types pay variable interest rates or are more flexible, such as liquid CDs. In general, you'll pay extra for that flexibility by means of a lower interest rate.

Managing Your CD Account After Opening

Let's say you've purchased a CD. Then what?

Protecting Your Investment: Avoid Early Withdrawals

Now comes the (potentially) easy bit: leaving your money alone. Once you've signed up for a CD, the bank or credit union will give you instructions on how to transfer funds to the new account. Once you've made a deposit, try to resist the temptation to withdraw money before your CD matures, unless you face emergency expenses. 

Preparing for CD Maturity: Future Actions

When your CD reaches the end of its term, you'll have some decisions to make. You will usually have three options:

• Roll the CD over into a new CD at that bank or credit union: You can choose a CD of the same term or a different one, if available.
• Transfer the funds into another account at that bank: Your options include savings, checking, and money market accounts.
• Withdraw the proceeds: You can ask the financial institution that holds your CD to transfer the money to an account at a different institution or mail you a check to deposit yourself.

If you don't provide any instructions before the bank or credit union's deadline, it will usually roll your CD proceeds into a new CD of the same term. If that's not your intention, missing the deadline could mean locking yourself into a CD with a subpar rate or paying an early withdrawal penalty to get your money out.

The Bottom Line

Certificates of deposit (CDs) are different from other types of accounts offered by banks and credit unions in that they typically pay higher interest rates but also require that you leave your money on deposit for a set period of time. They can be smart investments when you can align their maturity dates with a specific future need for your money. If you withdraw funds from your CD account before it matures, you'll usually have to pay an early withdrawal penalty.