How Does a Certificate of Deposit Work at a Bank?

A Certificate of Deposit (CD) is a type of savings product offered by banks and credit unions. It allows individuals to deposit a fixed sum of money for a specified period, in exchange for a fixed interest rate. CDs are considered a low-risk option for saving money, providing a predictable return. They differ from standard savings accounts by requiring funds to remain untouched for the agreed-upon term to avoid penalties.

Core Elements of a Certificate of Deposit

A CD’s structure is defined by characteristics that provide stability and predictability for the saver. The interest rate on a CD is set at the time of account opening and remains unchanged for the entire duration of the term. This fixed rate ensures earnings will not fluctuate with market conditions during the CD’s life.

CDs also come with a fixed term, which can range from a few months to several years. During this period, the deposited money is held by the financial institution and is not accessible without consequence. Principal protection means the initial amount deposited is guaranteed to be returned to the depositor at the end of the term.

Deposit insurance is a layer of security for CDs. CDs offered by banks that are members of the Federal Deposit Insurance Corporation (FDIC) are insured up to $250,000 per depositor, per insured bank, for each account ownership category. Similarly, credit unions offer equivalent protection through the National Credit Union Administration (NCUA). This federal insurance safeguards deposits.

Earning Interest with a CD

Interest accrues on a CD through compounding. Earned interest is periodically added to the principal balance, and subsequent interest calculations are based on this new, larger amount. Compounding can occur daily, monthly, or quarterly.

Financial institutions use the Annual Percentage Yield (APY) to compare various CD offerings. The APY reflects the total amount of interest earned over a year, taking into account compounding. This metric offers a more accurate representation of the actual return than the simple interest rate, making it the preferred figure for comparing different CD products.

Interest earned from a CD is taxable income by the Internal Revenue Service (IRS). This interest is treated as ordinary income and is subject to federal income tax rates. If a CD has a term longer than one year, interest is taxed in the year it is earned or made available, even if not withdrawn.

Practical Considerations for CDs

Opening a CD requires meeting minimum deposit requirements, which vary among financial institutions and specific CD products. Common requirements range from $500 to $2,500, with some “jumbo CDs” requiring $100,000 or more.

An early withdrawal penalty is a charge incurred if funds are removed before the maturity date. This penalty encourages depositors to keep their money invested for the full term. Penalties involve the forfeiture of a certain amount of interest, such as three months’ interest for shorter terms or up to 12 months’ interest for longer terms.

When a CD reaches its maturity date, the depositor has several options. Financial institutions provide a grace period, during which funds can be withdrawn without penalty or new instructions provided. If no action is taken during this grace period, the CD will automatically renew, or “roll over,” into a new CD of the same or a similar term at the current interest rate offered by the institution.