What is a CD and how does it work?

A certificate of deposit (CD) is a savings product that pays a fixed interest rate in exchange for keeping your money locked up for a specific term. Unlike savings accounts or money market accounts — where the interest rate can change at any time — a CD guarantees its rate from the day you open it until the maturity date. This makes CDs  a safe and predictable savings tools available at banks and credit unions.

When you open a CD account, you deposit a set amount for a defined period. In return, the bank or credit union pays you a fixed interest rate. When the CD matures, you receive your principal plus accumulated interest. If you withdraw money early, the bank usually charges a withdrawal penalty that reduces your interest.

This guide explores what a CD account is, focusing on the different types, their pros and cons, and whether CDs are worth it.

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CD meaning

Most people consider CDs safe deposit products you can typically buy from banks and credit unions. Like a savings account, a CD carries federal insurance. The Federal Deposit Insurance Corporation (FDIC) insures bank-issued CDs for up to $250,000. And if you purchase one through a credit union, the National Credit Union Administration provides identical protection.  

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How do CDs work? CD accounts explained

CDs follow a simple structure that rewards you for keeping money in place. Here’s how they work:

• Initial deposit: You deposit a lump sum into the CD account.
• Lock-in period: The bank holds your funds for the agreed term.
• Interest accrual: Your money earns interest at an agreed-upon rate.
• Maturity: You receive your initial deposit back plus earned interest.

While your money is locked away in the CD, your balance grows through compounding, which means you earn interest on your principal and previously earned interest. Most banks offer daily or monthly compounding. Daily compounding increases your earnings slightly faster because interest is added more frequently.

When your CD’s term ends, you can withdraw your funds, roll them into a new CD, or deposit the balance into another account. It’s important to note that you may be subject to income taxes on your earnings but not the principal.

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Are CDs safe?

Most people consider CDs safe. Federal insurance protects your deposits, and their value doesn’t depend on market performance. This makes them appealing during periods of market volatility or economic uncertainty. Here’s a closer look at the protections that make CDs a dependable place to store savings.

FDIC insurance

If you open a certificate of deposit at an FDIC-insured bank, the FDIC protects your deposits up to $250,000 per depositor, per financial institution, per ownership category. This coverage applies automatically when you open a CD at a participating bank. If the bank fails, the federal government returns your insured funds up to the stated limit.

NCUA insurance

Credit unions offer the same level of protection through the NCUA. The coverage limit mirrors FDIC rules and applies to all insured credit unions.

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Common types of CDs

Different types of CDs suit different savings needs. Each type offers a unique structure that affects access, risk, and potential earnings. Here are five of the most common CDs to consider.

IRA CDs

Individual Retirement Accounts (IRAs) are retirement savings vehicles. IRA CDs combine the stability of a CD with the tax advantages of an IRA. You can hold a CD inside a traditional or Roth IRA. Traditional IRA CDs are tax deductible, but withdrawals in retirement are taxed as income. You fund Roth IRA CDs with after-tax dollars, typically providing tax-free access to your contributions and qualified earnings later in life. IRA CDs work well for conservative retirement savers who want predictable returns.

High-yield CDs

High-yield CDs offer above-average interest rates and tend to outperform standard CDs. Typically, you’ll find these products at online banks with lower overhead, allowing them to pay more competitive interest rates than legacy financial institutions. These CDs help savers maximize returns without taking on additional risk.

No-penalty CDs

A no-penalty CD can allow early withdrawals without losing interest, which makes it more like a traditional savings account. This type of CD offers flexibility for savers who want access to funds but still want a fixed rate. While typically more competitive than standard savings accounts, no-penalty CDs tend to offer lower interest rates than traditional CDs that charge an early withdrawal penalty.

Brokered CD

You purchase brokered CDs through brokerage firms rather than banks or credit unions. You can access a wider range of terms and CD interest rates because brokerages source their CD selections from multiple financial institutions. The FDIC still insures your deposit as long as the issuing bank is FDIC-insured. But if you need access to your cash, you must sell your CD on the secondary market, which can result in a loss if interest rates have risen since you purchased your brokered CD.

Foreign currency CD

Foreign currency CDs let you hold funds in a currency other than U.S. dollars — like the euro or yen. While you can secure a higher interest rate with a foreign currency CD, you introduce a potential wrinkle: exchange-rate risk. When your CD matures, if you convert your funds back to U.S. dollars, the amount you receive depends on the currency exchange rate at the time. If the foreign currency has weakened against the dollar, you could lose money. These also have increased tax implications and reporting requirements.

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Top benefits of CDs

Here are the main advantages that CDs offer savers.

Better earnings

CD interest rates often beat traditional savings and money market account rates, especially in high-interest rate environments. Unlike other savings products, CDs let you lock in rates for the duration of your term.

Predictable returns

Unlike a market-based investment, CDs don’t generate variable returns. You’ll know exactly how much interest you’ll earn and how much money you’ll wind up with at your maturity date – provided no withdrawals are taken.

Ladder options

You may also consider using CD ladders, opening multiple accounts with varying maturity dates. This can offer regular access to funds, lets you lock in high rates when they’re available, and can protect you from downturns when rates drop.

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Key disadvantages of CDs

CDs provide stability but also have drawbacks you should consider. Here are three common limitations.

Limited access to funds

Most CDs charge an early withdrawal penalty making it costly to withdraw money before the maturity date. This lack of flexibility makes CD accounts less suitable for short-term, emergency fund savings.

Impact of inflation

If inflation rises faster than your CD rate, your real rate of return can diminish. CDs protect your principal, but they don't protect your purchasing power during inflationary periods.

Missing out on higher rates

If interest rates rise during the term of your CD, you're locked into your original CD rate until maturity. This can limit your earnings. Buying short-term CDs or using CD ladders can help mitigate this risk.

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What to consider before opening a CD

When you evaluate a CD, don’t just consider interest rates. Ideally, you want the CD you choose to align with your liquidity needs and savings goals.

Interest rates

If you think interest rates will rise, it may make sense to go with a short-term CD. While a CD rate may seem high today, remember it’s the interest rate you’re stuck with until your maturity date. If you anticipate lower interest rates going forward, locking in the current higher rate with a long-term CD can secure a higher yield.

Deposit amount

Most CDs require a minimum deposit. Make sure the amount you put in won’t be needed to cover expenses or emergencies. Also, consider how a CD aligns with your larger investment plan. If you have a long-term time horizon, your money might be better off in an investment focused on retirement rather than short-term savings.

Tax considerations

CD interest is taxable in the year earned, even if you don’t withdraw money – unless it is held within an IRA. If you have large amounts of money locked up in CDs, you might push yourself into a higher tax bracket due to the interest earned being taxable. To defer taxes, consider an IRA CD or a long-term investment such as a deferred annuity.

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What is a CD Ladder?

A CD ladder strategy spreads your cash across certificates of deposit with different maturity dates. For example, you might divide $3,000 equally in CDs with one-, two-, and three-year terms. As each CD matures, you have access to $1,000 plus interest earned. This approach can reduce interest rate risk and help give you more flexibility to access funds without having to worry about a withdrawal penalty.

Practical certificate of deposit examples

To understand how CDs work, let’s walk through two hypothetical examples.

1. Earning with a five-year CD

Suppose you deposit $5,000 in a five-year CD with a 5% APY. Over time, compound interest helps your savings grow. Here's how your earnings would look year by year (rounding the totals):

• Year 1: Earn $250 in interest. Balance grows to $5,250
• Year 2: Earn $263 in interest. Balance grows to $5,513
• Year 3: Earn $276 in interest. Balance grows to $5,789
• Year 4: Earn $289 in interest. Balance grows to $6,078
• Year 5: Earn $304 in interest. Your final balance is $6,382
  

2. Early withdrawal scenario

Imagine you deposit $10,000 in a five-year CD at a 5% APY but need to withdraw after three years. While you earn interest during that time, withdrawing before maturity leads to a penalty. Here’s how it works:

• Total interest earned: $1,576
• Early withdrawal penalty: $276 (equal to six months of interest)
• Net earnings after penalty: $1,300

Despite the penalty, you still can benefit from the account. This example shows why planning your CD term is important to avoid penalties.

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Secure your retirement savings with Gainbridge

While the typical interest rate on a CD can be higher than many savings accounts, a CD isn’t always the best place for your money. If you need funds to deal with unexpected expenses, a high-yield savings account can make more sense. If you’re thinking about long-term financial goals, CDs may lack many of the features of retirement investments. This is where Gainbridge comes in to offer a more structured long-term solution.

When you contribute to a fixed annuity from Gainbridge, you get a competitive interest rate, 100% principal protection, and a guaranteed income stream in retirement. Annuities offer the kind of security that helps ensure you don’t outlive your money. You also have the added benefit of earning a competitive interest rate in a product shielded from stock market volatility.

Explore Gainbridge digital annuities today to find a plan for your money that aligns with your financial goals.

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This article is intended for informational purposes only. It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice. For advice concerning your own situation please contact the appropriate professional. The GainbridgeⓇ digital platform provides informational and educational resources intended only for self-directed purposes. Guarantees are backed by the financial strength and claims-paying ability of the issuing insurance company. CDs are deposit accounts offered by banks and credit unions, insured by the FDIC or NCUA. Annuities are an insurance product offered by an insurance company and are not FDIC or NCUA insured.

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