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What is a certificate of deposit?

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Last editedDec 20202 min read

Whether you’re looking for a conservative investment outlet or are in the process of saving for a business goal, a bank CD might be a good option. So, what are CDs in finance, and how do they work?

What are CDs in finance?

The abbreviation ‘CD’ stands for certificate of deposit, a financial product offered by banks or other financial institutions like credit unions. You purchase a CD with a lump sum deposit, agreeing to leave it untouched with the bank in exchange for an interest rate premium.

The specific deposit terms, interest rates, and conditions will depend on the financial institution. Almost every brokerage firm or bank offers multiple types of CD options. Some banks charge for early withdrawal, while others don’t. It’s well worth shopping around, because the highest paying CDs offer more advantageous interest rates than even the best savings accounts.

Certificate of deposit vs. savings account

While both types of financial instruments are based on setting money aside, there are a few differences between CDs and savings accounts.

Both options yield returns over time, but while savings accounts let you change your balance with additional deposits and withdrawals, CDs require that your initial deposit stays put until its maturity date. Generally, the longer you’re willing to leave your deposit in the account, the more money you can make. As a result, a bank CD can be an attractive alternative to anyone who wants to earn more interest over time than they would with a checking or savings account.

How does a certificate of deposit work?

There are a few different types of certificate of deposit, varying by term length and interest rate. Yet no matter the terms, opening a bank CD works pretty much the same way as with any other bank deposit account. The main difference is that when you sign a contract, you’ll be agreeing to leave your deposit in place until the CD reaches maturity. This could be in as little as three months, or as much as 10 years or longer. Here’s what to look at when you’re comparing CDs:

  • Principal: This is the amount of money you’re agreeing to deposit with the bank in order to open your certificate of deposit.

  • Interest rate: Locked interest rates provide a clear, quantifiable return on your deposit. If the rate is fixed, this means that the bank can’t change it.

  • Term length: This refers to the amount of time you’re agreeing to leave funds deposited. If you withdraw before the end of your term, you’ll typically pay a penalty charge.

After you’ve agreed to a principal, term, and interest rate, you’ll sign the contract and receive financial statements every period. These give you an update regarding your current deposit amount with interest.

Is there a certificate of deposit risk?

Although no financial product comes entirely without risk, CDs are one of the safest investment or savings vehicles out there. With a fixed, guaranteed interest rate, there’s no chance that your return will be subject to market fluctuations. In comparison to stocks and bonds, CDs offer a less volatile option.

However, to ensure that there’s no certificate of deposit risk, you should make sure that you only make an investment with a federally insured or accredited banking institution.

What are the pros and cons of CDs?

There are several benefits to opening a certificate of deposit:

  • It offers a predictable rate of return in comparison with more volatile investments like stocks and bonds.

  • Although it depends on the different types of certificate of deposit, CDs can offer higher rates than comparable savings accounts.

  • It can help you save your money, since your deposit is locked away and cannot be touched.

However, a bank CD might not be the best option on every occasion. There are also a few drawbacks:

  • A CD isn’t as liquid as a regular savings account. You can’t liquidate your funds before maturity without penalties.

  • With fixed interest rates, you won’t benefit from a rise during the agreed-upon term.

  • You won’t reach the same earning potential as you might with stocks and bonds.

These pros and cons are all worth consideration to determine if a CD is right for you.

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