Certificates of deposit: How CDs work to grow your money

You probably already have a checking or savings account from which you pay monthly bills and cover daily expenses. You might even have a retirement savings account like a 401k or IRA. If you also have some extra money that you won’t need right away, consider growing it with a certificate of deposit (CD). A CD may give you a higher return than a traditional savings account, while still allowing you to withdraw your money after a set period of time that you select when you open the account.

What is a certificate of deposit?

A certificate of deposit (CD) is a term deposit offered by banks and credit unions. Think of it as a savings tool that lets you deposit a certain amount of money for a set period of time, at a fixed interest rate.

CDs typically offer higher interest rates than basic bank options, but withdrawing money prior to the maturity date can lead to a penalty. 

How does a certificate of deposit work?

Learn about the key concepts that determine how CDs work.

Maturity

Your CD reaches maturity at the end of the term you chose when you opened the account. Then, either you can withdraw the money, or you can reinvest in another CD. If you do nothing, a bank typically will automatically reinvest your money in another CD with the same term.

If you want to withdraw your money or move it into a CD with a longer or shorter term, you’ll need to let the bank know during the grace period of the CD. The grace period is a special, short period of time after the CD matures during which you can make changes to your account with no penalty. Then, you can transfer your deposit to your checking or savings account, or you can start a new CD with a different term.

Early withdrawal

If you withdraw money before the CD’s term ends, you’ll usually incur a penalty. The penalty can vary, but you might lose a portion of the interest earnings. Some CDs may not charge a penalty for early withdrawals.

Laddering

Many people who set money aside may try to take advantage of the higher interest rates CDs tend to offer while also attempting to keep their savings semi liquid. They often do this by purchasing more than one CD. For example, you might deposit money in a one-year, two-year, three-year, four-year and five-year CD — a strategy known as CD laddering. With this approach, one CD would mature each year, and you would be able to access the original funds and earned interest without paying a penalty. This also may be a valuable approach if interest rates increase throughout the broader economy because you are likely to earn a higher interest rate on a new CD account. When interest rates increase broadly, you are likely to earn a higher interest rate on a new CD account.

When should you consider a CD?

CDs may be a good choice if you have budgeted well and have some money in savings that you’re unlikely to need right away. Consider other CD pros:

• Low-risk investment: CDs from banks are generally FDIC-insured, meaning they are insured by the Federal Deposit Insurance Corporation. If your bank participates, your CD deposit generally is protected up to $250,000, making CDs a safer investment than stocks, which are not insured against loss of principal.
• Savings motivation: When you open a CD account, the penalty for withdrawing your deposit before the term ends can be a strong incentive not to spend money you planned to save. If you want to add extra protection to your savings goals, a CD may be a good option.

When is a CD not right for you?

If you’re uncertain about your spending plans for the next few months or years, or if you’ll need to take money out of savings soon for a major purchase, a CD may not be the best choice. The penalty for early withdrawal removes some flexibility and value in those cases.

Additionally, they’re not a good substitute for a broader strategy to invest for retirement, because they generally earn lower interest rates relative to other options, such as purchasing stocks, bonds or mutual funds. That means it can be harder to use CDs to accumulate the funds you’ll need for retirement.

What types of CDs are available?

You can choose from different types of CDs available on the market. Each type offers its own pros and cons.

Traditional CD

Traditional CD accounts are the most common and have fixed interest rates and terms. This means the interest rate and length of time you will keep your deposit in the account are set when you make the initial deposit, and they won’t change until the CD matures. Traditional CDs also come with a penalty if you withdraw your money before the account reaches maturity. But there are other types of CDs with different terms that could be a good fit for your savings plans.

Trade-up CD

A trade-up CD offers a lower interest rate at the beginning of its term than a traditional CD does. However, it also gives you an opportunity to earn more. If interest rates rise on CDs with similar terms before your CD matures, you can choose to trade up for it at least once during the term. If rates don’t rise, however, you could miss out on the higher interest rates offered by traditional CDs. A trade-up CD could be a good choice if you expect interest rates to increase soon.

Step-up CD

Like most CDs, a step-up CD has a set interest rate at the beginning of its term. A step-up CD also typically starts with a lower interest rate than a traditional CD with a similar term. But unlike other CDs, the rate on a step-up CD rises at specific stages over the life of the CD. For example, in a 28-month CD, the interest rate might rise after seven, 14 and 21 months. A step-up CD may be a useful option if you expect interest rates to rise, but you are concerned about having to choose the best time to increase the rate, as you would with a trade-up CD.

No-penalty CD

Suppose that you are interested in purchasing a CD, but you’re unsure about whether you may need the money before the CD term ends. A no-penalty CD, as its name suggests, does not require you to pay a penalty if you withdraw your money before the account matures. The tradeoff is that this type of CD generally offers a lower interest rate than that of a traditional CD, which do have a penalty for early withdrawal.

CDs can be part of a sound financial plan. To learn which kinds of CDs might be best for you, speak with your banker or accountant.

FAQs about certificate of deposits

Do CDs pay interest monthly or yearly?

CD interest payments vary by provider and product. U.S. Bank CDs typically make interest payments either at the end of the term or annually, whichever occurs first.

What are the downsides to a CD?

The potential downsides to a CD are limited liquidity, inflation risk, and opportunity cost. You can’t easily access your funds without facing a penalty, which may be a concern for people seeking high-liquidity investments. Additionally, CDs lock you into a fixed interest rate. This means if inflation rises above your interest rate, your investment loses some of its value. Similarly, if market interest rates rise during your CD term, you potentially lose out on better investment opportunities.

How much interest will my CD earn over the term?

Since you know your deposit amount and interest rate in advance, you can easily calculate your interest earnings using our CD calculator.

Ready to save? Explore CD rates at U.S. Bank today.