Certificate of Deposit

A certificate of deposit is a deposit account at a bank or credit union that pays a stated rate of interest on a fixed sum for a fixed period, and that restricts withdrawals before the period ends. The FDIC lists certificates of deposit among the deposit products it insures, alongside checking, savings and money market deposit accounts, so the money is covered on the same terms as any other deposit at the same institution.

The name to know is the regulatory one, because that is where the rules live. Federal banking regulation calls this a time deposit. Under 12 CFR 204.2(c)(1)(i) a time deposit is a deposit the depositor has no right to withdraw from within six days after the date of deposit unless the account carries an early withdrawal penalty of at least seven days' simple interest on amounts withdrawn in that window, and the regulation goes on to cover funds payable on a specified date, or at the expiration of a specified time, not less than seven days after deposit. That is the whole legal difference between a CD and a savings account. A savings deposit is defined by a notice right the bank almost never uses; a time deposit is defined by a maturity date and a penalty.

The federal penalty floor is far smaller than nearly every consumer guide implies, and that is the single most useful thing to know about breaking a CD. All 204.2(c)(1)(i) requires is a penalty of at least seven days' simple interest on amounts withdrawn within the first six days after deposit. It says nothing about a withdrawal in month four of a five-year term. The three months or six months or twelve months of interest a bank charges is a term of the deposit agreement, which is precisely why the figure varies so widely between institutions and between terms at the same institution. Regulation DD requires the penalty to be disclosed, not capped. So the document that determines what breaking a CD costs is the account agreement, and the number is worth reading before the money goes in rather than after.

Regulation DD's model clauses show how far that can reach. The model early withdrawal disclosure reads that the institution will or may impose a penalty if the depositor withdraws any or all of the deposited funds or principal before the maturity date, with the fee equal to a stated number of days, weeks or months of interest, or alternatively a stated dollar amount. Two things follow from the wording. The penalty is defined by a period of interest rather than by what the account has actually earned, so a CD closed early in its term can owe more than it has credited. And the bracketed reference to principal is not an accident, because the regulation contemplates agreements under which the shortfall comes out of the money deposited.

The partial-withdrawal rule is the mechanic almost nobody states, and it has a reclassification consequence. 204.2(c)(1)(i) provides that a time deposit permitting partial early withdrawals must impose additional penalties of at least seven days' simple interest on amounts withdrawn within six days after each partial withdrawal, and that if those additional penalties are not imposed, the account ceases to be a time deposit. It then becomes a savings deposit if it meets those requirements and otherwise a transaction account. Regulation DD's model disclosure carries a matching line, warning that a partial withdrawal can change the rate paid on whatever is left.

A brokered CD is a different risk from a bank CD, and the difference is the most consequential thing a reader can get wrong here. A brokered CD is issued by a bank but bought through a brokerage account. Rather than surrendering it to the issuing bank for a contractual penalty, an owner who wants out before maturity sells it on a secondary market at whatever price it will fetch, which moves with prevailing rates. If rates have risen since purchase, that price is below face value, and the loss is a market loss rather than a penalty. Deposit insurance still applies, but on a pass-through basis that depends on the deposit broker's records identifying the true owners properly. A bank CD surrendered early loses interest and possibly some principal to a penalty that is knowable in advance; a brokered CD sold early loses whatever the market says.

Two ordinary features cost real money and get little attention. Automatic renewal means a matured CD rolls into a fresh term of the same length at whatever rate the bank is then paying, with a grace period, commonly short, in which the depositor can withdraw or change the term without penalty. Miss it and the money is locked again, sometimes at a materially worse rate than the one that was just available elsewhere. And laddering, which means splitting a sum across several maturities so that one matures each year, is a way of keeping part of the money reachable without paying a penalty, at the cost of averaging the rate rather than catching the best one.

On tax, interest is ordinary income in the year it is credited and arrives on a Form 1099-INT. A penalty for early withdrawal appears in Box 2 of that form and is deductible rather than punitive, which published material on the early withdrawal penalty covers in detail.

You deposit a fixed sum, the bank quotes a term and an annual percentage yield that is fixed for that term, and interest is credited on a schedule the disclosure sets out. At maturity the money and the interest are yours to take, move or roll into a new term. Take any of it out before then and the deposit agreement's early withdrawal penalty applies to the amount withdrawn.

A hypothetical example of why the penalty matters more than the rate. Aisha puts $10,000 into a five-year CD paying 4%, and the agreement sets the early withdrawal penalty at twelve months of interest on the amount withdrawn. Four months in she needs the whole balance back.

Ignoring compounding, four months at 4% on $10,000 has credited roughly $133 ($10,000 × 0.04 × 4 ÷ 12 = $133.33). The penalty is twelve months of interest on the $10,000, which is $400. She receives $9,733.33 ($10,000 + $133.33 − $400), so the penalty has taken all of the interest and $266.67 of the money she put in.

Nothing about that is a violation. It is what a penalty defined as a period of interest does when a CD is broken early in its term, and it is why the penalty clause is the number to compare when two CDs quote a similar yield. Aisha's problem was the term, not the rate. The same $10,000 in a one-year CD, or split across a ladder of maturities, would have reached a maturity date long before she needed it.

Pros

• The rate is fixed for the term, so a CD locks in a yield that a savings account can have cut the following week.
• Federally insured on the same terms as any other deposit at the same institution, so the balance is not exposed to market losses.
• The maturity date is a commitment device, which suits money earmarked for a known date.
• Terms are short enough to be useful. A ladder of maturities keeps part of the money reachable each year without giving up the fixed rate on the rest.

Cons

• The money is not liquid, and the cost of reaching it is set by the deposit agreement rather than by any federal ceiling.
• A penalty measured in months of interest can exceed the interest earned so far and reduce the principal.
• Locking a rate cuts both ways. If rates rise during the term, the CD keeps paying the old one and getting out costs a penalty.
• Automatic renewal can roll the money into a fresh term at an uncompetitive rate if the grace period passes unnoticed.
• Interest is taxed as ordinary income in the year credited, even though the depositor may not touch it until maturity.
• A brokered CD sold before maturity can return less than face value, which a bank CD cannot.