A certificate of deposit (CD) is a low-risk savings tool that can boost the amount you earn in interest while keeping your money invested in a relatively safe way.
Like savings accounts, CDs are considered low risk because they are FDIC-insured up to $250,000. However, CDs generally allow your savings to grow at a faster rate than they would in a savings account.
In exchange for depositing your money into a bank for a fixed period (usually called the term or duration), the bank pays a fixed interest rate that’s typically higher than the rates offered on savings accounts. When the term is up (or when the CD matures), you get back the money you deposited (the principal) plus any interest that has accrued.
If you need to access your funds before the CD’s term ends, you are subject to an early withdrawal penalty, which can significantly reduce the interest you earned on the CD.
CDs come in varying terms and may require different minimum balances. The rate you earn typically varies by the term and how much money is in the account. In general, the longer the term and the more money you deposit, the higher the rate you are offered. (A longer term does not necessarily require a larger minimum balance.)
Like savings accounts, CDs earn compound interest—meaning that periodically, the interest you earn is added to your principal. Then that new total amount earns interest of its own, and so on.
Because of the compound interest, it is important to understand the difference between interest rate and annual percentage yield (APY). The interest rate represents the fixed interest rate you receive, while APY refers to the amount you earn in one year, taking compound interest into account.
There are a number of factors to consider when choosing a CD. First, when do you need the money? If you need it soon, consider a CD with a shorter term. But if you’re saving for something five years down the line, a CD with a longer term and higher rate may be more beneficial.