What are certificates of deposit (CD)?

Before 1975, when you asked if your bank or credit union offered certificates of deposit, you might have been greeted by quizzical looks or total mystification. Few financial institutions offered this new, "revolutionary" savings certificate. Skyrocketing interest rates in the early 1970s – as the prime rate approached 20% in a runaway inflation environment – threatened many financial institutions with disaster. Enter the certificate of deposit.

Technically, CDs were "created" in 1961, but their popularity didn't widely expand until the early to mid 1970s, primarily because of inflation problems. A certificate of deposit is a "time deposit" that carries an interest rate often higher than typical savings accounts. CD rates normally follow and mirror inflation rates.

How does a typical CD work?

Typical CDs provide that you agree to keep your deposit with your institution for three, six, or nine months, or from one to five years. Your interest rate is typically increases with the amount of time that you agree to keep your deposit.

But, this is not always true. Sometimes, rates are predicted to fall after some period. Therefore, you might see higher rates available for the short term (three, six, or nine months) than you're offered over two to five years.

Except in rare occasions, you are not permitted to add to or withdraw from your CD during the time period you've agreed to deposit your funds. When your CD comes "due" at the end of your agreed time period, you can renew it at current rates or cash it in and put your funds in another account of your choosing.

You can reinvest it in another CD of the same or a different period, deposit the money to a checking or savings account, or receive the cash and ride into the sunset.

What types of CDs are there?

The types of certificates of deposit offered vary from institution to institution. One bank or credit union might offer many choices of CD products with a myriad of interest rates and time periods, while others may offer only a few selections. This decision is totally up to individual financial institutions.

This makes for a sometimes-confusing menu of choices that require you to evaluate the terms available for deposit amounts and conditions with which you are comfortable.

Most CDs offer fixed rates for firm periods. For example, for a deposit of $1,000 to $5,000, Credit Union A will pay you 4% interest for a CD from three to six months, 4.5% for a CD from nine to twelve months, and 5%, 6%, and 6.5% for one, two, and three year CDs, respectively. The transaction is quite simple.

You agree to keep your money with the issuing institution for a guaranteed interest rate for a period. You might sometimes find a few more "creative" options. For example, certain CDs allow a one-time increase in funds. Others may provide for an interest rate bump during the life of the CD.

Have a large amount of money and looking for a better interest rate? You might qualify for a "jumbo" CD from some financial institutions that provide a higher rate in return for your commitment to deposit more money than required with a regular CD.

How are interest rates on CDs calculated?

The menu of interest rate calculations for CDs is simple. The most common choices involve interest earnings posted to your CD once, at the end of the term, or monthly/quarterly during the term.

You may find CDs that allow you to withdraw your interest amounts as they are earned. In many cases, your previous month/quarter earnings will compound – interest on interest – during the term of the CD.

On rare occasions, you can find CDs that might offer adjustable interest rates during the term based on the specific language of the certificate. These offerings tend to be available at times for longer CD terms. This feature may or may not benefit you depending on the conditions for interest rate changes.

How to get your funds in a CD before maturity

A certificate of deposit does not permit early withdrawal without a penalty. Unlike a savings account, which you can typically add to or withdraw from at will, a certificate of deposit is more of a "contract" between you and the issuing institution.

The bank or credit union agrees to pay you a stipulated interest rate in return for your guarantee that you will leave your funds on deposit for the prescribed term. A request to withdraw all or part of the deposited amount will normally generate a penalty.

See also: Compare CD rates