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A certificate of deposit (CD) is a savings account offered by banks and credit unions to their customers. Generally, this product offers a relatively high rate of interest compared to traditional savings vehicles, but it entails a lockup period during which an investor is unable to access or trade their money.
What Is a Certificate of Deposit?
A certificate of deposit (CD) is a savings vehicle that provides interest compensation in exchange for a commitment to leave the amount invested on deposit, or in a bank account, for a predetermined amount of time. Early withdrawal typically results in a loss-of-interest penalty. While rare, some CDs impose particularly burdensome penalties that can result in loss of principal, or the original sum of money put into the investment.
CDs are structured for various lengths of time, with most spanning anywhere from one month to five years. They can reflect fixed-rate or variable-rate terms, but fixed arrangements are, by far, the most prevalent. Generally, the longer the term, the higher the interest rate offered — provided all other variables remain the same.
Deposit requirements vary but can be as low as a few hundred dollars. Typically, rate offerings are staggered, with higher deposit amounts garnering higher rates of interest, again, if all other factors remain constant.
Regardless of the specific terms, CDs are broadly popular with investors that value high-quality, stable-value, interest-bearing vehicles, but can afford to lockup their money for a period. Understanding when and how to use CDs to achieve financial goals is a key piece of financial literacy.
How Does a CD Work?
The process for investing in a CD begins the same way as the opening of a traditional checking or savings account. You are required to apply online or in-person with the issuing financial institution. A primary difference is that the initial deposit into a CD is generally the only one you will make, while a traditional bank account allows for periodic deposits.
Another key difference relates to the very specific terms and conditions associated with a CD, such as maturity date, interest rate and early withdrawal penalty. The maturity date is the date the investor is allowed to withdraw money from the CD.
- A $10,000 CD investment is made on Jan. 1, 2021.
- The term is two years (maturity on Jan. 1, 2023).
- The nominal rate, or stated annual rate, is 2.5 percent, with daily compounding of interest.
- The early withdrawal penalty amounts to six months of interest, which approximates $125.
$10,000 × .025 ÷ 12 × 6 = $125
Incidentally, the nominal rate of 2.5 percent reflects an annual percentage yield (APY) of 2.53 percent. The APY, which is also referred to as the effective annual rate, reflects the effect of compound interest. The computation is below.
Given these terms, at the end of the two-year period, the investor can expect to receive the following proceeds from the initial $10,000 investment:
What Are the Types of CDs?
The example above outlines the characteristics of a standard CD, but alternative structures exist. The most common CD variations, which offer optionality to an investor, are outlined below.
- No-penalty CD
- This structure allows for penalty-free early withdrawal; it is typically paired with a relatively low interest rate.
- Jumbo CD
- A jumbo is structured the same as a standard CD, but it entails a higher minimum balance, sometimes as much as $100,000 or more. In return, a jumbo will generally offer a comparatively high interest rate.
- Bump-up CD
- This structure allows you to request a higher rate if prevailing marketplace conditions warrant it. Typically, only a single request is permitted, but some longer-term CDs allow for multiple requests.
- Step-up CD
- A step-up option provides for specified rate increases administered by the issuing institution at periodic intervals. For example, the rate on a 36-month step-up CD might be scheduled to increase every six months.
- IRA CD
- This is essentially a regular CD that has been designated to be held in a tax-advantaged individual retirement account (IRA).
Are CDs Safe?
On the surface, CDs are one of the safest, most stable investments you can make. However, it’s important to be cognizant of the unique risks associated with this type of instrument. The most prominent considerations are outlined below.
Credit Risk Exposure
Credit risk is nonexistent to negligible for most CDs. A properly structured CD is fully ensured up to $250,000 for an individual account and $500,000 for a joint account. The Federal Deposit Insurance Corporation (FDIC) provides insurance for CDs issued by banks, and the National Credit Union Administration (NCUA) provides insurance for CDs issued by credit unions (via the National Credit Union Share Insurance Fund). Above the insured limits, loss of capital is possible, but the risk is fairly remote for CDs issued by financially sound institutions. It can increase significantly for CDs issued by poorly capitalized institutions.
Inflation Risk Exposure
While credit risk is remote, a notable exposure for some CDs is inflation risk. This is particularly worrisome for longer-term products, with maturities extending up to and beyond five years. For these instruments, a substantial uptick in inflation can quickly overshadow the interest income offered, leaving an investor with less real wealth at maturity.
Another pertinent exposure, oftentimes the greatest, is liquidity risk. As noted above, a CD requires you to lockup your money for a stipulated period. If you violate this requirement and redeem your funds early, you will most certainly face an early withdrawal penalty. The penalty usually equates to a certain number of months of interest (like the six months of interest specified in the example above). However, some CDs impose especially onerous penalties that can result in loss of principal. This is rare, but possible.
Is a CD Right for Me?
Whether or not a CD is a sensible investment for you is highly dependent on your tolerance for risk, which is a function of your near-term liquidity needs, appetite for volatility and investing time horizon. In the right situation, a CD can provide an excellent complement to a portfolio of cash and longer-term investments, such as stocks, bonds and alternative investments.
When Does a CD Makes Sense?
If you have a relatively short investing time horizon and can comfortably lockup your money, then a CD could be sensible. If you have a very low tolerance for volatility, a CD makes even more sense. However, before you invest in a CD, be sure to evaluate the wealth-eroding effect inflation can have on your money, especially if you are entertaining longer-term products.
When Doesn’t a CD Make Sense?
If you have erratic, near-term liquidity needs and may require immediate access to your money, a CD is not appropriate. Additionally, if you have a relatively long investing horizon, such as the accumulation period prior to retirement or the spend-down period during retirement, a CD is not a great option. For you, investing in some combination of stocks, bonds, alternative investments, and possibly, annuities, offers a much more rewarding risk/return profile, with higher growth and/or income potential.
Is a CD Sensible for Retirement?
As suggested above, on an absolute basis, a CD investment is not advisable for someone with a long-term investing horizon, such as retirement. However, it can make sense for an investor with a segmented, or goals-based, approach to investing.
- Known spend in zero to six months
- Likely spend in six to 12 months
- Potential spend in one to two years
- Potential spend beyond two years
In this scenario, a CD investment could be sensible for the six to 12-month bucket. Let’s expound.
Assume Jim has a life situation that calls for him to hold 12 months of living expenses ($50,000) in liquid, stable-value assets. Jim has that much saved, but he doesn’t want to simply store the cash in his savings account, which yields zero. So, he has carefully thought about things and determined, in a worst-case scenario, he will only need half the annual estimate within the next six months.
This analysis prompts Jim to invest $25,000 in a one-year CD at 1 percent. In doing so, he has prudently carved-out the less time-sensitive half of his $50,000 liquidity cushion and optimized his financial position. This type of strategic, time-based investing is a prime example of how a CD can make sense in a long-term portfolio.
Other Important Considerations
In addition to weighing your risk tolerance, you will want to consider the tax treatment of CDs as well as the institution’s automatic renewal policy when deciding whether to invest in a CD.
When you open a CD, the money you invest and the interest it earns is locked up until the maturity date. However, the issuing institution periodically applies interest to your account and reports it at regular intervals, usually, via a monthly or quarterly statement. As this interest is reported, it is taxable. So, while you won’t receive any of the funds until the CD matures, you are liable for the income tax on any accrued interest.
Once a CD matures, unless you specify otherwise, most institutions will automatically renew it at the prevailing interest rate, following a specified grace period. This might not be in your best interest. You may need the funds. Alternatively, you may be able to invest them in a higher-yielding CD with another institution. Therefore, it’s important to keep the CD maturity date on your radar. If you want to redeem the funds, you will need to provide formal notice to the issuing institution.
Alternatives to CDs
On the shorter end of the maturity spectrum, CDs are comparable to other high-quality instruments, such as U.S. Treasury bills, commercial paper and money market funds, which are comprised of an assortment of the other assets, including CDs. CDs are generally less liquid than the other instruments, but investors are compensated for this via comparatively higher interest rates.
Another highly liquid alternative is a high-yield savings account, which is typically offered by online banks. The absence of a traditional, brick-and-mortar overhead structure can make these vehicles quite competitive from a yield perspective. However, unlike a fixed-rate CD, the rate on a high-yield savings account can be changed at any time.
CDs vs. Annuities
Consumers who are looking for a low-risk alternative to CDs may consider a fixed annuity, specifically a multi-year guaranteed annuity (MYGA), as an option.
Both products lock up a lump sum and allow it to accumulate interest over a set period. And each guarantees a rate of return and offers principal preservation.
However, comparing CDs to annuities is not apples-to-apples. CDs are generally a short-term investment, while annuities are not. Other differences include the tax advantages and death benefits that are available with annuities but not with CDs.
A qualified financial advisor can guide you through the similarities and differences between annuities and CDs and help you pick the product that best fits your needs.
A CD is a bank account that compensates the account owner with a higher rate of interest than traditional savings accounts. The interest differential results from the requirement that the investor lockup his money for a specified period. Generally, the longer the lockup period, the higher the interest rate offered.
As discussed previously, a variety of terms, conditions and considerations are associated with this type of investment. A high-level list of pros and cons is provided below.
- Very safe investments with zero credit risk below insured limits
- Stable value product with zero volatility (unlike stocks, bonds, and alternative investments)
- Can offer more competitive rate than other types of short-term investment
- Can facilitate disciplined savings behavior for individuals inclined to spend cash
- Relatively easy to establish, with an array of traditional and online options
- Entails a lockup period and an early withdrawal penalty
- Interest rate earned often fails to keep pace with inflation, which erodes purchasing power
- Relatively inferior option for longer-term investment horizons
- Accrual basis taxation on interest earned does not align with cash inflow
- Auto renewal feature can be problematic
3 Cited Research Articles
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- Consumer Financial Protection Bureau. (n.d.). Annual Percentage Yield Calculation. Retrieved from https://www.consumerfinance.gov/rules-policy/regulations/1030/a/
- Federal Deposit Insurance Corporation. (n.d.). Deposit Insurance. Retrieved from https://www.fdic.gov/resources/deposit-insurance/
- National Credit Union Administration. (n.d.). Share Insurance. Retrieved from https://www.mycreditunion.gov/share-insurance