What Is a Certificate of Deposit (CD)?

It’s time to talk about CDs. And, no, we don’t mean compact discs—you can keep your dusty Creed and Backstreet Boys albums on the shelf, thank you very much. We’re talking about certificates of deposit.

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CDs are basically savings accounts with slightly better interest rates than more traditional bank accounts, but you must keep the money in the CD for a certain amount of time.

They’ve been thrown around since the 1960s as part of investment and savings strategies to help your money grow a little while it’s waiting to be used. But in reality, CDs are just a way for banks to get quick access to your cash.

Here’s the lowdown on CDs: They may be low-risk, but they’re also low-reward.

We’ll get to all of that soon. First, let’s find out what a certificate of deposit actually is and how it works. Then we’ll explain why CDs probably aren’t the best place to park your money and why they’re definitely not a good way to invest for your future.

What Is a Certificate of Deposit (CD)?

A certificate of deposit (CD) is a special kind of savings account that comes with a fixed interest rate in exchange for keeping your money there for a set period of time. When the CD matures (that’s the word banks use for when a CD reaches its end date), you’ll get your original deposit back plus the interest you earned.

The annual percentage yield (APY)—the total amount of interest you earn over one year—is usually higher than what you’ll find for an average savings or money market account. But you know there’s a catch. There’s always a catch. If you cash out your CD before it matures, you’ll face a penalty—usually several months’ worth of interest that’s been building up in your account.

Traditional CDs are a low-risk—but also mostly low-reward—way to earn interest on your money. As far as types of accounts go, CDs are about as set-it-and-forget-it as they come. Basically, you make the initial deposit, and then you don’t do anything but wait for it to mature.

CDs are federally insured up to $250,000, which makes them a safe place to put your money. But in most cases, that’s about all a CD is going to be: a place to put your money, not grow your money.

How Do CDs Work?

When you open a CD, you’re depositing money the bank can use to make loans and investments. That’s right: Banks will use your money to fund other people’s debt. Sounds backward already, doesn’t it? When loan applications are piling up, a bank might run a CD promotion offering higher-than-normal APYs to build their cash flow so they can fund all their new loans. That’s going to get a hard pass from us!

Here’s another tricky thing about CDs: Most of them come with penalties for early withdrawals. Imagine you’ve got $5,000 in a two-year CD, but a year in, you need $2,500 of it. You can take it out, but you’ll get hit with a penalty that’ll eat into the interest you’ve already earned.

Now, let’s walk through the different parts of a CD and how they work.

Bank or Credit Union Policies

Nearly all banks offer CDs, but their APYs, terms and minimum deposit requirements can vary. You might find one bank with a great APY but a steep deposit requirement (in the tens of thousands range). So, if you’re dead set on opening a CD and want to get the most bang for your buck, you’ll need to shop around.

Not all CDs are created equal. Before you sign on the dotted line with any bank or credit union, make sure you understand the factors that determine how much interest you can earn.

Interest Rate

Part of the appeal of CDs for a lot of folks is a higher APY than a traditional savings or money market account. Banks set their own APY for CDs, so one bank could have a sweeter deal than another. For example, online banks and credit unions may offer APYs two to three times higher than a brick-and-mortar location. 

Keep in mind, the APY you’re given at the time of deposit will stay with you the entire time. It’s fixed, even if rates go up or down. That means there’s a good chance you might lock in a fixed rate days before a higher one comes along. And if that’s the case, the bank says, “Too bad, so sad—no take-backs,” and you’re stuck with the lower APY for the length of the CD’s term.

Principal

When it comes to CDs, the principal is the amount of your initial deposit. The more you deposit, the more total interest you’ll earn.

Some CDs have no minimum deposit requirement, while others (called jumbo CDs) may require a deposit of $100,000 or more. If a bank is in a bind, they might offer a higher APY and a shorter term in exchange for a bigger deposit from you.

This is a big thing to remember: Traditional CDs don’t allow you to deposit more money after you put in your initial deposit. If you open a CD with a $1,000 principal amount, you won’t be able to make any more deposits after that.   

Term

Finally, the term (or length of the CD) will help you figure out how much interest you’ll make over time.

CD terms can range anywhere from a few months up to several years—usually between three months and five years—and sometimes even longer than that in special cases.

Usually, the longer the term, the better the rate. (But in some situations, short-term CDs might actually offer more attractive rates—especially in a high-interest-rate environment, like we’ve seen over the past few years.)  

And just like the interest rate, once you’ve picked the term length of your CD, that’s it—it’s pretty much set in stone. At the end of the term, you might be able to renew your CD, or you can simply withdraw the principal and interest and walk away. 

How Much Interest Do CDs Earn?

While the national average APY on CDs these days remains pretty low, some of the top CDs offer rates in the 3.5–4.5% range.^1,2

Let’s see what this looks like in real life. Take Adam, for example. He has $1,000 to put into a CD. He finds an online bank offering a 3.5% APY on one-year CDs. That means Adam will turn over $1,000 to his online bank for 12 full months, earning 3.5% interest on his initial deposit. At the end of the 12 months, Adam’s CD will be worth $1,035. That’s fine . . . but you could easily skip your weekly trip to Starbucks for a few weeks and add $35 to your savings that way.

Now let’s up the ante a little. Say Adam has $5,000 to put into a five-year CD with a 4.0% APY. Remember, this means he won’t have access to his money for five full years. If he withdraws his funds, even a portion of them, before his CD matures, he’ll get hit with a penalty. At the end of five years, Adam’s CD will be worth about $6,083 and some change.

Scenario	Initial Deposit	CD Term	APY	Total Interest Earned	Final Value at Maturity
1-Year CD	$1,000	1 year	3.5%	$35	$1,035
5-Year CD	$5,000	5 years	4.0%	$1,083	$6,083

So, CDs might earn you more interest than a savings or money market account, but are they actually part of a winning savings or investment strategy?

Think about that. A bank gets to have your money for five years. You can’t touch it or use it or even look at it! And for what? A whopping $216 per year in interest when your money is finally freed up on your CD’s maturity date? It’s better than nothing, but this isn’t the type of return that’ll change your life.

Is It a Good Idea to Get a CD?

People who open CDs (or are thinking about opening one) usually do so for one of three reasons—to invest, to save for emergencies, or to save for big purchases. Let’s talk about each one of those.

CDs are never a good idea for your investments.

Let’s be real clear here—CDs are nothing more than glorified savings accounts with slightly higher interest rates. But even those rates are barely enough to keep up with inflation, which makes things more expensive over time (no wonder Dave Ramsey likes to call CDs “certificates of depreciation”). That’s not a winning strategy for long-term investing, people!

Instead, we recommend investing for retirement with tax-advantaged retirement accounts like 401(k)s and Roth IRAs. When you invest with those accounts, you give your money the best opportunity to grow and get some sweet tax advantages along the way.      

Remember that $5,000 five-year CD Adam had? Well, if he took that same $5,000 and invested it in the only thing we recommend—growth stock mutual funds with a long track record of strong returns—he could have more than $8,000 after five years (based on an average rate of return of 10–12%). Now that’s more like it!

CDs are a terrible place to put your emergency savings.

Do some CDs have slightly better interest rates than most savings accounts? Sure. But since you can’t access most CDs without penalty, they make zero sense as a place for your emergency savings. Because if you put money in a one-year CD and your water heater breaks six months later, you’ll probably have to pay a fee just to get your hands on that cash.

The bottom line: You need your emergency savings to be liquid (which means your money is easily and quickly accessible)—and CDs are not that. Stick with an online high-yield savings account or money market account for your emergency fund.

CDs might help you save for big purchases—but you probably have better options.

If you’re planning on saving up to make a big purchase (like a down payment on a house or a car) within the next five years, then it might make sense to look at a CD.

Still, the lack of access to your money during the term of the CD could make things complicated if you want to put an offer on a house or see a great deal on a reliable used car before the term is up. Not to mention that you won’t be able to deposit more money into your CD beyond the initial deposit (the principal).

Unless you’re getting an outrageously good rate on a CD and you’re willing to keep the money there until the end of the term, you should probably use a high-yield online savings account or money market account to hold your sinking funds for big purchases.     

	Certificate of Deposit (CD)	Traditional Savings Account	Money Market Account (MMA)/High-Yield Savings Account (HYSA)	Tax-Advantaged Retirement Account (401(k), IRA, etc.)
Interest Rate or Annual Rate of Return	Moderate to high (around 3.5–4.5% for fixed terms)	Low (around 0.4%)	Moderate to high (around 3.5–4.5%)	Depends on investments (average annual rate of return is 10–12% for stock market)
Access to Funds	Locked in until maturity, penalties on early withdrawals	Full access anytime	Full access anytime (there may be some transfer limits)	Restricted until age 59½ (withdrawal penalties may apply)
Risk Level	Very low	Very low	Very low	Depends on the investment (stocks have higher risk, bonds have lower risk)
Liquidity	Low	Very high	High	Low (funds tied up until retirement)
Minimum Balance	Varies, but often $500–1,000	Usually none	Usually none for HYSAs, but typically $500–5,000 for MMAs	Varies by plan or provider
Tax Treatment	Interest is taxable annually	Interest is taxable annually	Interest is taxable annually	Tax-deferred (traditional) or tax-free growth (Roth)
Best For	Guaranteed returns over a set time	Emergency fund or short-term savings	Emergency fund or short-term savings	Long-term retirement and investment growth
Downside	No access without penalty before term ends	Very low returns	Rates can fluctuate, may have minimum balance requirements	Penalties for early withdrawal, some investment risk

A Better Way to Invest

Could your money be doing more for you outside of a CD, especially on the investing front? The simple answer is yes.

When it comes to saving for retirement, you don’t need the old bank-first investment strategy or the shiny, new investment toy. You need a simple strategy that works.

Investing doesn’t have to be intimidating or overly complicated. Make an investment plan with a financial advisor who can help you invest with confidence.

 

This article provides general guidelines about investing topics. Your situation may be unique. To discuss a plan for your situation, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.