What are certificates of deposit and how do they work?

Not to be confused with the metallic music-playing discs of the '80s and '90s, CDs — formally known as certificates of deposit — are a savings option still very much in play. This particular savings account option locks up your money for a certain period of time and in exchange, you earn interest, often at a better rate than your standard savings account.

While not the right solution for all savings goals, CDs can be worthwhile for a number of purposes.

What is a certificate of deposit?

A certificate of deposit (CD) is a type of savings account that "pays a fixed interest rate on money held for an agreed-upon period of time," said Investopedia. CDs are usually offered by banks and credit unions, "although credit unions often refer to them as share certificates," said Bankrate. Brokerage firms may offer them as well.

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CDs can have interest rates that are "higher than savings accounts," said Investopedia, but in exchange, you "lose withdrawal flexibility," as you will pay a penalty if you withdraw your funds from a CD before the amount of time you had agreed to deposit your funds for — known as the CD's term — has elapsed.

How do CDs work?

With a CD, "you usually can't add money to one after you open it or withdraw the money whenever you want," said Bankrate. Rather, you deposit a certain amount upfront that then remains in the CD for the length of its term. "Terms can be as short as one month to as long as 10 years," and there may be a minimum opening deposit necessary to open the CD, which can be in "amounts such as $500, $2,500 or more," said Bankrate.

Once you deposit your money, it will start earning interest, usually at a fixed interest rate. "On the date the CD matures, or when the term length is over, savers can get their money back, in addition to the interest earned over time," said CNBC Select.

However, if you take out money before then, you will owe an early withdrawal penalty, the amount of which "can vary depending on your bank and your CD's term length, but it's usually the interest earned, or the interest that you would have earned, over a certain number of days or months," said CNBC Select.

What are the benefits and risks of CDs?

The major upside of CDs is the potential for "returns without much risk," said NerdWallet. With a CD, you can "avoid the volatility of the stock market and earn a return that's typically better than other savings accounts." Even better, your funds are insured, which means up to a certain amount "is guaranteed to be returned to you if a bank goes bankrupt," said NerdWallet.

One downside, however, is that CDs tend to offer "lower returns than other types of investments, like stocks," said Bankrate. You may also need to have a lump sum ready to open one up. And again, you should ideally not touch your funds until the term is up to avoid a penalty — which may be an imposition in the event of an emergency.