How Do Certificate of Deposit (CD) Accounts Work?

A Certificate of Deposit (CD) account offers a structured way to save money, providing a fixed interest rate for a specific duration. This type of savings vehicle requires funds to be held for a predetermined period, known as the term. CDs are generally considered a low-risk option for growing savings, yielding higher interest rates than traditional savings accounts.

Core Mechanics of CD Accounts

A Certificate of Deposit functions as a time deposit, meaning funds are committed for a set period, ranging from a few months to several years. In exchange for this commitment, the financial institution provides a fixed interest rate that remains constant throughout the CD’s term, ensuring a predictable return. This fixed rate typically offers a higher yield compared to standard savings accounts.

Deposits in CDs are protected by federal insurance, with the Federal Deposit Insurance Corporation (FDIC) or the National Credit Union Administration (NCUA) insuring accounts up to $250,000 per depositor, per institution, in each ownership category. Interest on a CD can be simple or compound. Most CDs compound interest daily or monthly, meaning earnings grow on both the principal and accumulated interest, which is reflected in the Annual Percentage Yield (APY) quoted by the issuer. The “maturity date” signifies the end of the CD’s term, at which point the principal and all earned interest become accessible to the account holder.

Common CD Variations and Their Features

Several types of CDs offer different features to suit various financial needs. No-penalty CDs, also known as liquid CDs, allow for early withdrawal of the full balance without incurring a penalty, typically after an initial holding period. While providing increased flexibility, these CDs often come with slightly lower interest rates than traditional CDs. Another variation includes step-up or bump-up CDs, which offer the potential for the interest rate to increase during the CD’s term, usually at predetermined intervals.

Jumbo CDs are designed for larger deposits, generally requiring a minimum initial investment of $100,000 or more, and often offering higher interest rates in return for the substantial deposit. Brokered CDs are purchased through brokerage firms, providing access to a wider range of CDs from various issuing banks and sometimes offering higher yields. These may be traded on a secondary market. Callable CDs include a provision that allows the issuing bank to redeem, or “call,” the CD before its maturity date, and these CDs often offer higher interest rates to compensate for this call risk.

Opening, Funding, and Maturing a CD

Opening a CD account involves selecting a financial institution and choosing a CD type and term that aligns with one’s financial objectives. The process is similar to opening other bank accounts, requiring personal identification such as name, address, and Social Security number. Once selected, the CD is funded with a single initial deposit. This funding can typically be done via transfer or by mail. Unlike savings accounts, additional deposits usually cannot be made to a CD after it has been opened.

A significant aspect of traditional CDs is the early withdrawal penalty, which is incurred if funds are removed before the maturity date. These penalties typically involve the forfeiture of a portion of the interest earned, often equivalent to several months of interest, and vary by institution and the CD’s term, with longer terms generally having higher penalties. When a CD reaches its maturity date, account holders have several options. They can withdraw the principal and earned interest, or the CD may automatically renew for a new term at the prevailing interest rate. Most institutions provide a grace period after maturity, allowing time to make decisions about the funds without penalty.