How Does a CD Account Work?

If you're planning to make a big purchase in the next few years and have some of the money on hand now, you might consider putting it into a certificate of deposit (CD). A CD can be thought of as a federally insured savings account, but with a few key differences.

With a CD, you agree to leave your money in the account for a set period of time, which can range from a few months to a number of years. In exchange, the bank or credit union that issues your CD will pay you a guaranteed return on the money, typically higher than you'd get on a regular savings account. Find out how CDs function and how you can make them work best for you.

Before You Open Your CD Account

A certificate of deposit is a relatively simple investment product and buying one is a pretty straightforward process. Even so, there are a few important things to consider.

1. Decide How Much You Want To Invest

First, you should determine how much money you can invest in a CD. This is important because CDs are not very liquid—that is, you can't get your money out easily if you need it in an emergency. Because of this, you should only put money into a CD that you are fairly sure you aren't going to need before the CD matures. CDs have early withdrawal penalties (more on that below), which makes them a bad choice for emergency savings or other money you might want at a moment's notice.

2. Determine What Kind of CD You Want

Virtually every bank and credit union in the U.S. offers at least one certificate of deposit and many have a wide array of them. Not only is your local brick-and-mortar bank a potential source for your CD, but so is every bank or credit union in your community, as well as every bank that accepts online customers nationwide. Investopedia's regularly updated rankings of the best bank CD rates, for example, track about 200 banks that offer CDs.

There are three main considerations when choosing a CD. The first is the term you want to hold it for—in other words, how long you are willing to leave your money in the CD before you can get at it again. CD terms range from a few months to a few (or even many) years. If you aren't sure when you're likely to need your money back, it's better to err on the side of caution. You can always choose a CD with a short term and then re-invest the money in another CD after it matures.

Finally, consider whether a standard or more specialized type of CD would be best for you. The standard CD pays a set interest rate and charges penalties for early withdrawals. There are other types that pay variable interest rates or that are more flexible, such as liquid CDs. In general, you'll pay extra for that flexibility through a lower interest rate.

After You've Opened Your CD Account

Let's say you've purchased the CD you've chosen. Then what?

1. Try To Leave Your Money Alone

Now comes the (potentially) easy bit: leaving your money alone. Once you've signed up for a CD, your bank or credit union will give you instructions on how to transfer funds to the new account. Once you've done that, try to resist the temptation to withdraw money before your CD matures, unless you face a genuine emergency. 

The early withdrawal penalty on a typical CD can be substantial, in some cases exceeding any interest you've earned. So you could even lose some of the money you invested in the first place.

2. Plan for When Your CD Matures

When your CD reaches the end of its term, you'll have some decisions to make. Normally, you will have three options: 

• Roll the CD over into a new CD at that bank or credit union. You can choose a CD of the same term or a different one.
• Transfer the funds into another account at that bank. Your options include savings, checking, or a money market account.
• Withdraw the proceeds. You can ask the financial institution that holds your CD to transfer the money to an account at a different institution or mail you a check to deposit yourself.

If you don't provide any instructions before the bank or credit union's deadline, it will usually roll your CD proceeds into a new CD of the same term. If that's not your intention, missing the deadline could mean locking yourself into a CD with a subpar rate or paying an early withdrawal penalty to get your money out.

The Bottom Line

Certificates of deposit (CDs) work differently from other types of accounts offered by banks and credit unions. They typically pay higher interest rates but also require that you leave your money on deposit for an agreed-upon period of time. Otherwise, you'll usually have to pay an early withdrawal penalty.