Certificates of Deposit

How it works

A CD begins with a lump sum handed to a bank for a fixed term, commonly anywhere from three months to five years. In exchange the bank issues a certificate promising a stated rate that holds until maturity. Because the bank knows the funds cannot leave without a penalty, it can lend that money out for longer than it would against an ordinary savings balance, which is why a CD normally pays more than the same bank's savings account.

The deposit itself is insured by the FDIC at a bank or the NCUA at a credit union, up to the standard $250,000 per depositor, per insured institution, per ownership category, covering principal plus interest that has accrued.

A direct CD is opened and redeemed with the bank itself. A brokered CD is the same bank obligation, but it is purchased through a brokerage account, held there, and exited by selling into a secondary market rather than by redeeming with the issuing bank.

Several variants change the shape of the payoff. Callable CDs let the bank end the contract early if rates fall. Step-up CDs raise the rate on a preset schedule. Bump-up CDs let the holder request one rate increase during the term. No-penalty CDs permit a single free withdrawal after a short lock-in. Left untouched, most direct CDs auto-renew into a new term at the bank's prevailing rate after a short grace window at maturity.

What it pays

The rate is quoted as an APY fixed for the entire term, set at purchase and unchanged afterward. That fixed quality is the product's whole purpose: a known payment in exchange for giving up access to the money.

The rate itself is priced off the bank's expected cost of funding over that term, which tracks the shape of the Treasury curve plus a spread reflecting how eager the bank is for new deposits. When the curve is inverted, short-term CDs can pay more than long-term ones; when it slopes upward in the ordinary way, longer terms pay more.

Banks sometimes offer promotional odd-term CDs — thirteen months, seventeen months — priced above their standard rate grid specifically to attract new balances. Callable CDs carry a higher headline rate for the same reason a call option has value: the bank is buying the right to exit early if rates drop, and it pays extra for that right.

Brokered CDs trade at a price, so their yield to maturity reflects that price rather than the coupon alone — a CD bought above par yields less than its stated coupon, and one bought below par yields more.

Costs and taxes

A direct bank CD carries no explicit purchase fee; whatever cost exists is folded into the offered rate. A brokered CD is typically sold at par with the broker's compensation embedded in the price, and exiting one before maturity costs a bid-ask spread and sometimes a dealer concession on top.

The early-withdrawal penalty on a direct CD is a real, disclosed cost, usually stated as a number of months of interest. Withdrawing very early in the term can eat into principal, not just forgone interest.

Interest is ordinary income at the federal level and is generally taxable at the state level as well. On CDs with terms longer than a year, interest is taxed as it accrues each year, even if it is not actually paid out until maturity.

An early-withdrawal penalty is reported separately on Form 1099-INT and can be deducted as an adjustment to income, so the taxpayer is not taxed on interest that was ultimately surrendered.

Liquidity and time commitment

The funds are committed for the stated term. A direct bank CD can be broken before maturity, but only by paying the disclosed penalty. A brokered CD generally cannot be redeemed early at all — the only way out is to sell it to another investor at whatever price the secondary market is offering, which can sit below par if rates have risen since purchase.

A ladder — equal amounts placed in CDs maturing at staggered intervals — converts this otherwise locked instrument into a rolling stream of maturities, so some portion of the money becomes available on a regular schedule without ever triggering a penalty.

Grace periods at maturity tend to be short, often a week to ten days, after which an unattended CD can auto-renew into another full term. Beyond opening the account and marking the maturity date on a calendar, there is little ongoing effort involved.

How it goes wrong

Reinvestment risk is the mirror image of the certainty the CD was bought for: the term ends, rates have fallen, and the same principal now earns much less going forward. Auto-renewal compounds this problem, since an unattended CD often rolls onto the bank's standard rate grid rather than whatever promotional rate applied to the original purchase.

Call risk works against the holder in the same direction: a callable CD gets redeemed by the bank exactly when rates have dropped, returning cash that can only be reinvested at the new, lower level.

Selling a brokered CD before maturity in a rising-rate environment usually means selling below par, turning what looked like a safe, fixed-rate holding into a realized loss if liquidity is needed early.

Balances placed at a single institution above the FDIC or NCUA limit are simply uninsured, a meaningful risk when a large sum is concentrated at one high-rate bank chasing yield. And over a long fixed term, inflation can quietly erode the after-tax real return to negative even though every scheduled payment arrived exactly on time.