A CD – short for "certificate of deposit" – is a type of investment you can buy from a bank to earn interest. When you buy a CD, you pay a fixed amount of money and specify a fixed period of time over which the CD will earn interest. At the end of the time period, you can cash out the CD and reinvest the money elsewhere.
CDs are low-risk investment options, which makes them attractive. You can even cash them out early, but you will incur an early withdrawal penalty as required by federal law.
Read More: Certificate of Deposit Pros and Cons
Purchasing a CD from the Bank
You can invest in a CD from most banks, although some banks may require that you also open a deposit account. You will need to pay the bank the entire purchase price of the CD, which is typically $5,000 or more, and specify the length of your term. CDs are held in terms of years, although you can also buy six-month CDs at a lower yield.
The interest rate you earn on the CD will depend upon the rates available at the time as well as the amount of your deposit and the length of your term. If you make a larger deposit or specify a longer time period, the bank will generally offer you a higher rate of interest.
Read More: What does CD Stand for in Banking
How CDs Earn Interest
Once you buy a CD, interest begins to accrue until the end of the specified term. The interest is compounded; that means you earn interest on the interest. Rather than paying you interest on the amount you deposited only, the bank will pay you interest throughout the term and also pay you interest on the interest you've earned.
For example, if you bought a one-year CD for $20,000 earning 1.5 percent interest compounded monthly, at the end of the term, your CD will be worth $20,302.07, which means you earned $302.07 over the year. If interest had not compounded, your yield would only be $300. You can visit CIT.com for a CD interest calculator.
Penalties for Early CD Withdrawal
Federal law requires that banks set a minimum monetary penalty for customers who try to cash in a CD early. The government sets the floor on that requirement; if you withdraw from the CD within the first six days after investing, your interest will be at least seven days' worth of interest. After that, each bank has its own rules about how much to charge you.
Often, the penalty is calculated based on the amount of interest you would have earned during a set time. For instance, your bank's CD rules might state that if you make an early withdrawal, you'll be charged 90 days' worth of interest. If you're unsure of the penalty, check the fine print with your bank.
Requesting an Early CD Withdrawal
Your bank's website should provide its procedure for making a withdrawal or closing a CD early. Some banks may allow you to perform the entire action through their websites, including agreeing to and paying the penalty and having the funds transferred to your deposit account. Other banks may require you to appear at a branch in person, with identification, to make the withdrawal.
Read More: How Do I Redeem a CD?
Alternatives to Early Withdrawals
Making an early withdrawal on a CD will cost you interest, but there are other options you can pursue. Some banks will allow you to make interest-only withdrawals on the CD without penalty. So, if you bought a CD for $50,000 last year and have earned $600 worth of interest, you might be able to withdraw $600 or less from the accrued interest without penalty.
Your bank may also offer no-penalty CDs. However, those have much lower interest rates and don't allow you to withdraw small amounts. You must cash in the entire CD and close the account.
In brief, CDs are a safe way to make a short-term investment, but they work best if you can afford to put the money away for the term of the CD without needing to access it. Otherwise, you may lose the interest you've earned.
Rebecca K. McDowell is an attorney focused on debts and finance. She has a B.A. in English and a J.D. She has written finance and tax articles for Zacks and eHow.