What is a certificate of deposit?

Understanding certificates of deposit

A CD is a type of savings product that pays interest over a set period of time, typically a month to 10 years. Most CDs come with a fixed interest rate, but there are some variable CDs available, too. Unlike savings accounts, which allow you to access your funds at any time, CDs are meant to be untouched for the duration of the term. In exchange for this commitment, CDs typically offer a higher interest rate than traditional savings accounts.

Since CDs work best in a “set-and-forget” nature, they’re the best option if you want to earn a relatively high interest rate on your investment but won’t need immediate access to these funds. CDs are not ideal for emergency savings accounts or for individuals who need to quickly liquidate their savings. In a pinch, you will be able to withdraw your funds from a CD, but the early penalty fees can cost you.

» MORE: Best CDs

How do CDs work?

When opening a CD, you agree to leave your money deposited for the specified term, while the bank agrees to pay the agreed-upon interest rate. Once the CD matures, you can withdraw your funds or choose to roll over the CD into a new term.

CDs are considered a low-risk investment option, as they are insured by the Federal Deposit Insurance Corporation (FDIC) at most banks up to the applicable limit (typically $250,000).

Here are the key terms and concepts you need to know before taking out a CD:

• Interest rate: The interest rate is the rate of return offered on a CD. It is expressed as a percentage of the deposit amount and is fixed for the term of the CD.
• Term: The term refers to the length of time that the deposit will be held in the CD. It can range from one month to multiple years.
• Maturity date: The maturity date is the end date of the CD, at which point you can either withdraw your deposit plus the accumulated interest or roll over the CD into a new term.
• Principal: The principal is the amount of money initially deposited into the CD. This is the amount that will earn interest over the term of the CD.

You can apply for a CD in person at your local bank or online if your bank offers that service. Many online banks offer CDs with higher interest rates than traditional banks.

How to choose a CD

When you’re choosing a CD, there are several factors to consider to ensure the CD aligns with your investment goals and timeline. Here's what to look for:

• Finding the highest CD interest rate: The longest term doesn’t always have the highest interest rate. Different banks and credit unions will offer a higher promotional annual percentage yield (APY) for select CDs, which can have terms as short as three months.
• Short-term versus long-term CDs: It is best not to lock up all your savings in one long-term CD. A better solution is CD laddering, which is a strategy of spreading your investment across CDs with different maturity dates so that you have regular access to your funds.
• Minimum deposit requirements: Minimum deposits on average range from $0 to $2,500. Some higher-APY accounts might require a higher deposit.
• Early withdrawal penalties: Most banks will charge you a certain amount of interest if you touch your funds before the CD maturation date. This can make all of your hard work of saving pointless. Look for no-penalty CDs if you are not sure if you can commit to a full CD term.

Alternatives to CDs

“The question of alternatives to CDs is one that has become more common over the last year as interest rates have gone up,” said Clint McCalla, a senior wealth manager at LourdMurray in San Diego. “The alternatives I see most frequently utilized include money market funds, direct U.S. Treasury bill purchases and high-yield savings accounts.”

Each CD alternative has benefits and drawbacks, depending on your financial goals.

• Money market accounts (MMAs): With a MMA, you have slightly more access to your funds versus a CD, but there are still restrictions, such as how often you can withdraw funds. MMAs are considered low-risk but are still subject to market fluctuations. Most CDs are guaranteed or come with a fixed rate that can be locked in for your desired term.
• U.S. Treasury bills (T-bills): T-bills are safe investments because they are backed by the U.S. government. You can purchase T-bills with a minimum purchase of $100 and choose a maturity date between four and 52 weeks. These investments typically earn less interest than CDs, though.
• High-yield savings accounts: High-yield savings accounts typically have higher APYs than traditional savings accounts, but are not always as high as promotional high-interest CDs. High-yield savings accounts’ rates rise and fall with market conditions, but it is also easier to access your funds.

» MORE: What is a money market account?

Bottom line

Choosing a CD can be a smart investment option for those seeking a secure, low-risk place to park their money. However, if you need access to your funds before the maturity date, you may face penalties that will cost you.

Compare the current CD rates with MMA and high-yield saving accounts to see which is the best choice for you.