What happens when you open a CD

When you open a certificate of deposit, you give a bank or credit union a lump sum of money for a set period of time — usually anywhere from three months to five years. In exchange, the bank pays you a fixed interest rate, and you agree not to touch that money until the term ends. On the maturity date, you get back your original deposit plus all the interest earned.

The bank uses your money during that time to make loans and invest. That's why they pay you interest — they're borrowing from you. The longer you lock your money away, and the larger your deposit, the higher the interest rate typically is. A one-year CD pays less than a five-year CD at the same bank, because the bank has your money for longer.

CDs are insured by the FDIC (Federal Deposit Insurance Corporation) up to $250,000 per account holder per bank. That means if the bank fails, your money is protected up to that limit. This makes CDs one of the safest places to put money, though the trade-off is that your interest rate will be lower than riskier investments.

Key Takeaways

  • You deposit a fixed amount of money for a fixed time period and receive a fixed interest rate in return.
  • You cannot withdraw the money before the maturity date without paying an early withdrawal penalty, usually several months of interest.
  • Interest rates on CDs are higher when the term is longer or when you deposit more money.
  • Your deposit is FDIC insured up to $250,000, making CDs a low-risk savings tool.
  • When the CD matures, you can withdraw the money, open a new CD, or let it roll over into another term at the bank's current rate.

How interest accrues and compounds

The interest rate on a CD is fixed for the entire term. If you open a two-year CD at 4.5%, that rate does not change, even if market rates drop to 2% or rise to 6%. You know exactly what you will earn from day one.

Interest compounds, meaning you earn interest on your interest. Most banks compound daily or monthly. A $10,000 CD earning 4.5% compounded daily will earn slightly more than one compounded monthly, because the interest gets added to your balance more often. When interest is added, the next calculation includes that new amount.

You do not receive the interest until the CD matures. Some banks let you withdraw interest before maturity without penalty, but the principal stays locked. Most do not offer this option. You simply wait until the maturity date, then collect everything at once.

Early withdrawal penalties and what they cost

If you need your money before the CD matures, you can withdraw it, but the bank will charge an early withdrawal penalty. This penalty is usually expressed as a number of months of interest. A common penalty is three months of interest, meaning if you withdraw early, the bank subtracts three months' worth of earnings from what you receive.

On a $10,000 CD earning 4.5% annually with a three-month penalty, you would lose roughly $112.50 if you withdrew after one month. If you withdrew after two years of a three-year term, you would lose the same $112.50 — the penalty does not scale with how long you held the CD. Some banks charge a flat dollar amount instead, or a percentage of the deposit.

The penalty can eat into your principal if you withdraw very early. If you opened a one-year CD at a low rate and withdrew after two months, the penalty might exceed the interest you earned, leaving you with less than you started with. This is why CDs work best for money you know you will not need.

What happens when a CD matures

On the maturity date, your CD stops earning interest. The bank sends you a notice, usually 10 to 30 days before maturity, telling you what happens next. You have a few options: withdraw the money, open a new CD, or do nothing.

If you do nothing, most banks automatically roll over your CD into a new term at the current interest rate. If rates have risen, you benefit. If rates have fallen, you lock in a lower rate. Some banks give you a grace period of seven to ten days after maturity to withdraw without penalty before the rollover happens. Check your CD agreement to know your bank's policy.

If you want to move your money elsewhere, you can withdraw it and deposit it at another bank or invest it differently. There is no penalty for withdrawing after maturity. If you want to keep the money in a CD but shop for a better rate, this is the time to do it.

How CD rates compare to other savings accounts

CD rates are higher than regular savings accounts because you give up access to your money. A typical savings account might pay 0.01% to 0.5%, while a CD might pay 4% to 5% depending on the term and current market conditions. The longer the term, the higher the rate usually is, because the bank has certainty about how long it can use your money.

CD rates move with the broader economy. When the Federal Reserve raises interest rates, banks raise CD rates. When the Fed cuts rates, CD rates fall. If you lock in a CD when rates are high, you protect that rate for the entire term. If you wait and rates drop, you will earn less on a new CD.

Money market accounts sometimes pay rates close to CDs but let you withdraw money without penalty. High-yield savings accounts offer flexibility but lower rates than CDs. The choice depends on whether you need access to the money and how much extra interest matters to you.

Laddering CDs to balance rate and access

Many people use a strategy called CD laddering to earn higher rates while still having access to some money each year. Instead of putting all your money in one five-year CD, you split it into five one-year CDs. Each year, one CD matures, and you can withdraw that money or reinvest it.

If rates rise, you can reinvest the maturing CD at the new higher rate. If rates fall, you still have four CDs earning the original higher rate. This approach gives you more flexibility than a single long-term CD while still earning more than a savings account. The trade-off is that you earn less than you would from a single five-year CD, because the shorter terms pay lower rates.

Laddering works best when you have a larger amount to split and when you do not need all the money at once. It requires discipline to reinvest each maturity rather than spend the money.

Tax treatment of CD interest

Interest earned on a CD is taxable income. The bank will send you a 1099-INT form at the end of the year reporting how much interest you earned. You report this on your tax return and pay income tax on it at your ordinary tax rate.

If you earn more than $10 in interest from a single bank, the bank must issue a 1099-INT. Some banks issue them for smaller amounts anyway. Keep your own records of interest earned in case there is a discrepancy.

If you withdraw early and pay a penalty, you can deduct the penalty from your taxable interest income on your tax return. This slightly reduces the tax hit, but you still owe tax on the net interest you kept.

Frequently Asked Questions

Can I withdraw money from a CD before it matures?

Yes, but you will pay an early withdrawal penalty. The penalty is usually three to six months of interest, though it varies by bank and CD term. In some cases, the penalty can exceed the interest you earned, leaving you with less than your original deposit. Check your CD agreement for the exact penalty before you open it.

What is the difference between a CD and a savings account?

A CD pays a higher interest rate but locks your money for a set time. A savings account lets you withdraw anytime without penalty but pays much less interest. CDs are for money you will not need for months or years. Savings accounts are for emergency funds or money you might need soon.

Do I have to pay taxes on CD interest?

Yes. CD interest is ordinary income and is taxed at your regular income tax rate. The bank reports the interest on a 1099-INT form, and you report it on your tax return. If you withdraw early and pay a penalty, you can deduct the penalty from your taxable interest.

What happens if the bank fails?

Your CD is protected by FDIC insurance up to $250,000. If the bank fails, the FDIC pays you your deposit plus accrued interest up to that limit. This makes CDs one of the safest places to keep money. If you have more than $250,000, split it across multiple banks to stay within the insurance limit.

Should I ladder my CDs or buy one long-term CD?

A long-term CD pays a higher rate but locks all your money for years. Laddering gives you access to some money each year and lets you reinvest at new rates if they rise. Laddering is better if you might need the money or want flexibility. A single long-term CD is better if you do not need the money and want the highest possible rate.