What Is a Certificate of Deposit (CD)?

Remember when CDs were everything? And of course, you had to have a Discman. Ah, simpler times! Well, kind of like how compact discs haven’t aged well, neither have the kind of CDs I’m talking about today. Certificates of deposit, or CDs, are part of a dated (we’re talking 1960s) investment strategy that were created to help banks, not you. Sure, they may be low risk, but they’re also low reward.

When it comes to saving for retirement, you don’t need the old, bank-first investment strategy, or the shiny, new investment toy. You need a simple strategy that works.

But first, let’s find out what a certificate of deposit actually is and why CDs aren’t part of a solid investment plan. Let’s break it down.

What Is a Certificate of Deposit (CD)?

A certificate of deposit (CD) is a special kind of savings account that comes with a fixed interest rate. Basically, it’s like giving a bank or credit union a loan from your own pocket. In exchange for lending them a lump sum of your money for a fixed amount of time, they agree to pay you interest until the CD “matures” (that’s the term banks use for when a CD reaches its end date).

The annual percentage yield (APY)—that’s just the total amount of interest you earn over one year—is usually higher than what you’ll find for an average savings or money market account. But you know there’s a catch. There’s always a catch. If you cash out your CD before it matures, you’ll face a penalty—and it could cost you months or even years of interest that’s been building up in your account.

So, OK, CDs might earn more interest than a savings or money market account, but are they actually part of a winning savings and investment strategy?

How Do CDs Work?

CDs are a low-risk—but also mostly low-reward—way to earn interest on your money. As far as money things go, CDs are straightforward, easy to set up, and require little to no maintenance. They are about as set-it-and-forget-it as they come. Basically, you make the initial deposit, and then you don’t do anything but wait for it to mature.

CDs are federally insured up to $250,000, which makes them a safe place to put your money. But in most cases, that’s also about all it’s going to be: a place to put your money, not grow your money.

When you “invest” in a CD, you’re loaning a bank your money. Sounds backwards already, doesn’t it? And how about this: Did you know that banks will use your money to fund other people’s debt? That’s right, when loan applications are piling up, a bank may run a CD promotion offering higher-than-normal APYs to gain access to cash flow needed to fund all their new loans. That’s going to be a hard pass for me!

Here’s another tricky thing about CDs: Most of them come with penalties for early withdrawals. That means if one year into a two-year CD term you need $2,500 of your $5,000, expect a penalty that will eat into the interest you’ve already earned.

How Much Interest Do CDs Earn?

Not all CDs are created equal. Before you sign on the dotted line with any bank or credit union, make sure you understand the factors that determine how much interest you can earn.

The Bank or Credit Union

Nearly all banks offer CDs, but they won’t all offer the exact same APY and terms or require the same amounts to open the account. You might find one bank with a great APY but a steep deposit requirement (in the tens of thousands range). So, if you’re dead set on opening a CD and want to get the most bang for your buck, you’re going to need to shop around.

Interest Rate

Part of the appeal of CDs for a lot of folks is a higher APY than a traditional savings or money market account. Banks set their own APY for CDs, so one bank could have a sweeter deal than another. But let’s get some perspective on this thing, people. Today’s interest rates for CDs span a broad range. How broad? Well, online banks and credit unions may offer APYs two to three times higher than a brick-and-mortar location. 

Market chaos, inflation, your future—work with a pro to navigate this stuff.

But I’m going to let you in on a not-so-secret secret. Average APYs on a two-year CD these days are around 0.20%.¹ For a five-year CD, around 0.32%.² And you know what three times 0.20% is? If you guessed still less than 1%, you’re right! So maybe hold off on buying that Mercedes with your CD a little longer!

Plus, you might lock in a fixed APY days before a higher one comes along. And if that’s the case, the bank says, “Too bad, so sad—no take backs,” and you’re stuck with the lower APY for the length of the CD.

Let’s see what this looks like in real life. Take Adam, for example. He has $1,000 to put into a CD. He finds an online bank offering a 0.50% APY on one-year CDs. That means Adam will turn over $1,000 to his online bank for 12 full months, earning 0.50% interest on his initial deposit. At the end of the 12 months, Adam’s CD will be worth $1,005. Five whole big ones. Seriously, I’d rather keep my money, skip my weekly trip to Starbucks, and hand myself $5.

Let’s up the ante a little. Say Adam has $5,000 to put into a five-year CD with a 0.75% APY. Remember, this means he won’t have access to his money for five full years. If he withdraws his funds, even a portion of them, before his CD matures, he’s going to get hit with a penalty. At the end of the five years, Adam’s CD would be worth $5,190 and some change.

Think about that. A bank gets to have your money for five years. You can’t touch it or use it or even look at it! And for what? A whopping $190 in interest when your money is finally freed up on your CD’s maturity date? I don’t know about you, but this isn’t the type of return on investment I’m looking for.

Principal

When it comes to CDs, the principal is how much you initially deposit. That number varies bank to bank and offer to offer. If a bank is in a bind, they might offer a higher APY and a shorter term in exchange for a bigger deposit from you. There are CDs with no minimum requirement and some that could go upwards of $100,000. Those are called jumbo CDs. They sound fun, but they don’t make for a wise long-term investment. 

Term

Finally, the term—or length of the CD—will help you figure out how much interest you’ll make over time. CDs can range from six months to 20 years . . . in some cases even longer than that! Banks will often pick unusual lengths of time, like 13 months or 17 months, to make their offers stand out. The APY you’re given at the time of deposit will stay with you the entire time. It’s fixed, even if rates go up or down. Think wisely about how long you’re willing to part ways with your money in exchange for a low interest rate.

If you choose to invest in a CD, you can rest easy knowing a few things:

• Your money is safe and insured up to $250,000.
• It’s almost impossible to lose money in a CD.
• You’re guaranteed a fixed amount of interest when you let the CD mature.

But could your money be doing more for you? The simple answer is yes.

Is It a Good Idea to Invest With a CD?

Let's be real clear here, CDs are nothing more than glorified savings account with slightly higher interest rates. But even those rates aren’t enough to keep up with inflation, which makes things more expensive over time. That’s not a winning strategy for long-term investing, people!

If you’re at the point in your life where you’re saving for retirement or investing to grow your wealth, you want your money to do more than just sit there in a CD.

Remember that $5,000 five-year CD Adam had? Well, if he took that same $5,000 and invested it in the only thing we recommend—growth stock mutual funds with a long track record of strong returns—he could have more than $8,000 after five years (based on an average rate of return between 10–12%). Now that’s more like it!

Listen, when you invest in solid mutual funds with decades of positive returns, you can earn so much more on your money than if it were sitting in a CD. It’s time to put your money to work!

A Better Way to Invest

Investing doesn’t have to be intimidating or overly complicated. If it feels that way, then you’re working with the wrong people. If someone responsible for handling your hard-earned money can’t walk you through their plan simply and clearly, then they’re not the investment professional you need.

Make an investment plan with a SmartVestor Pro instead. They’re not here for the hard sell—they’re here to help you invest with confidence. Don’t just settle for a CD when you could be earning so much more.

For help mapping out your investment plan, check out SmartVestor.

This article provides general guidelines about investing topics. Your situation may be unique. To discuss a plan for your situation, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.