What is a Certificate of Deposit (CD) and How Does it Work?

Reginald Calaguas, Senior Preferred Banker, First Republic Bank
June 30, 2022

  • A certificate of deposit (CD) is a savings tool that often pays higher interest rates when compared to a typical savings deposit account.
  • A CD earns interest at a fixed rate over a set period of time known as the term.
  • Withdrawing cash from a CD before it matures generally results in a penalty fee.

Savings accounts are a popular choice among those who’d like a safe place to store their money while possibly earning interest. However, there are other options worth considering that may allow you to earn even more interest on cash, especially if you don’t need easy access to it. One strong example is a certificate of deposit (CD).

CDs work somewhat similarly to savings accounts: You deposit cash and accumulate interest. There are several key differences, though — CDs mature over a fixed term, and you’ll pay a penalty for withdrawing your money early. Before your invest, it’s important to understand how a CD works so you can decide if it’s the right fit for your monetary goals.

How do CDs work? Definition and explanation

A certificate of deposit (CD) is a time deposit account that pays a fixed interest rate over a period of time (generally ranging from 30 days to 5 years). Any early withdrawals of funds before the set maturity date come with a penalty fee.

Typically offering higher interest than traditional savings accounts, CDs are a potentially great way to save for short- or long-term goals. In most cases, the longer the term of the CD, the higher the interest rate. CDs typically have no fees unless funds are withdrawn before the maturity date.

How does CD interest work?

CDs generally have fixed interest rates dictated by several factors, including the market at large. These rates are usually higher (and more stable) than those associated with traditional savings accounts. CD interest compounding periods vary but are typically daily or monthly.

It’s worth noting that certain products, like bump-up CDs, may allow the investor to increase their interest rate under certain circumstances.

Are CDs a safe investment?

CDs are generally considered a safe investment because you can’t lose money the way you might with higher-risk investments, like traditional stocks. Instead, you’re guaranteed your initial deposit plus interest as outlined in your CD terms. The only way you’ll lose money is if you try to withdraw early and must pay the penalty.

Additionally, funds invested in CDs are federally insured up to $250,000 per depositor by the Federal Deposit Insurance Corporation (FDIC), providing protection for your peace of mind. Safety is just one of many advantages a CD has to offer.

Different types of CDs

Not all CDs are created equal. There are several types of CDs available to those looking to save their money — each with special considerations that should be reviewed before choosing which one to use. A few of the types of CDs you may encounter include: 

  • High-yield CD: Like high-yield savings accounts, high-yield CDs offer higher interest rates than traditional CDs. They’re typically available via online banks, which save money by avoiding the costs of brick-and-mortar locations.
  • IRA CD: Some may use CDs to help save for retirement. When funds from an individual retirement account (IRA) are invested into a CD, it’s called an IRA CD.
  • Liquid CD: A liquid CD allows you to withdraw funds prior to maturity, without penalty, starting the seventh day after the initial deposit. However, the tradeoff is these CDs often pay lower interest rates.
  • Jumbo CD: A jumbo CD is a CD that requires a large minimum deposit — usually around $100,000. These often pay a higher rate of return tied to the large upfront deposit requirement.
  • Bump-up CD: These CDs may allow you to raise your interest rate (based on the market) before the CD matures, though there are often limitations on how often you can do so.
What Is a CD ladder?
Though it’s not a type of CD, the CD ladder is a CD investment strategy worth considering. CD ladders involve investing in several CDs with different term lengths, so the funds mature at different times. This allows portions of your CD-invested cash to become available more frequently than if you’d invested the full amount in a single long-term CD.

 Advantages of CDs

There are several advantages to saving with a CD. Learning the benefits of a CD as a viable savings tool can help you feel more confident with your choice as well as ensures you work towards your financial goals. 

  • Higher interest rates: Depending on the type of account, a CD will almost always yield a higher interest rate than other savings deposit accounts.
  • Safety: CDs fall under the list of bank account categories insured by the FDIC, up to $250,000 per depositor, per account, per ownership category, so you know your money is safe.
  • Predictable returns: In contrast with other investment vehicles, CDs offer predictable, guaranteed returns on the funds you put in. You set aside a specific amount at a fixed rate for a specific amount of time, so you don’t have to worry about performance. 
CD Interest Example
CDs are known for their predictability: For example, if you place $10,000 in a CD at 2.25% for one year, with interest compounded daily, you’ll know exactly how much you’ll have at the end of that year — $10,228, representing an annual percentage yield (APY) earned of 2.28%.

Disadvantages of CDs

While investing in a CD has its advantages, there are a few disadvantages to consider before setting one up. 

  • Early withdrawal penalty: Money in a CD is locked for a set period and can only be withdrawn at maturity; otherwise, a significant early withdrawal penalty applies.
  • Due diligence: If your CD is longer than one month, your bank will likely inform you when your CD term is about to expire. If you somehow miss the notifications your account could automatically roll over into a new CD. This makes it harder or more costly to access your cash before your new term limit is up. Rates are also subject to change at maturity and your new CD may have a different rate than your previous one. Be sure to monitor your CD to ensure you are able to access your money once it becomes available. First Republic clients can set up CD maturity reminders in Online Banking

CD vs. other savings tools

CDs are not the only savings option available to you. You should consider all the savings tools banks offer before choosing one to fit your financial needs and goals. 

  • Savings account: A savings account is a common deposit account type offered by banks. They’re designed to hold money for longer periods of time, so they tend to have tighter transaction restrictions than checking accounts. Funds stored in traditional savings accounts often (but not always) accumulate interest. Unlike CDs, interest rates for savings accounts can change at any time based on federal policies and market conditions.
  • Money market: A money market account is another type of savings deposit account that offers benefits including limited check writing and limited transaction privileges. However, you may be limited to six withdrawals a month. Like savings accounts, the interest rates for these accounts can also change at any time after the account was opened. Rates are usually lower than those provided by CDs.

Keep in mind that there’s no need to choose one type of savings account. A combination of several account types may benefit your savings plan in the long run.

First Republic’s Money Market Accounts
First Republic offers both Money Market Savings, for those who want the benefit of attractive interest rates, and Money Market Checking accounts, for those looking for the convenience of accessing funds via check or ATM card while earning interest.

How do I know if a CD is right for me?

A CD offers a lot of positives, but it is important to understand all the details and conditions before signing on the dotted line. If you have unused funds earmarked toward a specific financial goal — such as buying a house, financing a loved one’s education or saving for emergency cash or for retirement — then the possibility of opening a CD should be explored. You may benefit from:

Low risk: A CD gives you the opportunity to explore new financial tools while having a portion of your money is safely invested and earning interest.

Potential for reward: If you have unused funds from a larger project, investing in a CD can give you some return on your funds.

However, remember that any early withdrawals before the maturity date will likely incur fees and funds cannot be added to a CD during its term. If you want the flexibility of having immediate access to your funds in an emergency situation, you may want to explore a shorter-term, a money market account or a checking account instead.

Try the First Republic CD Calculator
If you feel a CD may suit your financial goals, visit the First Republic CD calculator to see potential earnings at different interest rates and term lengths before you invest.

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