Here's What Happens When a Young Investor Starts a CD

Certificates of deposit (CDs) have become popular among young investors as their interest rates have increased. It's not difficult to find CD rates over 5.00% right now.

But CDs aren't right for everyone. They can be restrictive compared to other investments, so young investors need to understand what happens when they open a CD to determine if this is the best option for their funds. Here are four basics you should know.

1. Your money will be locked away

You've probably noticed that CDs have term lengths attached to them. For example, you may have seen 12-month, 3-year, and 5-year CDs advertised online or marketed through your bank. This is because every CD has a specific time for which you agree to hand over your money and leave it locked away.

This is important to understand because the concept of a CD is that you give your money to a bank in exchange for a specific rate of return. Let's say you put $2,000 into a 12-month CD with a 5.00% APY. If you take the money out six months early, you'll be charged fees (see below), and your earnings will be about 2.50%.

For this reason, choose a CD term length that you feel comfortable with so you're not tempted to take your investment out prematurely.

2. You'll be penalized if you take the money out early

This part goes hand in hand with the CD terms, but it deserves its own section because young investors may not be familiar with CD fees. For terms less than 24 months, banks generally charge 90 days of simple interest on the amount you withdraw early. CDs with terms longer than 24 months usually have a penalty fee of 180 days of simple interest.

Let's say you open a 3-year CD that pays 5.00% and put $5,000 into it. But after one year, you decide you need the money and take it all out. In this scenario, you could be charged about $122 in fees.

To avoid this, don't put any money into a CD you need for upcoming expenses or an emergency fund.

3. You'll get a fixed interest rate

One of the great things about CDs is that the interest rate is fixed. As long as you don't take your money out early, your money will earn the rate you're quoted.

This is especially good news right now because you can find CDs that pay 5.00% or even higher. But not all will. The average APY on a 12-month CD is just 1.74%.

Your bank may not be the best place to buy a high-yield CD. Instead, comparison shop online to get the best yield rates. Putting $3,000 into a 2-year CD with a 5.00% APY could earn you more than $307 in interest, while investing the same amount over the same period with a 1.76% APY will earn you just $106.

4. You'll owe taxes

Young investors may not know that any interest you earn could be subject to taxes. And CDs are no exception.

CDs are taxed just like income, and at tax time, you'll receive a 1099-INT from the bank reporting the interest you've earned.

This is important to consider when deciding how much money to put into a CD: the interest rate, and your tax bracket. If the interest earned from a CD pushes you into a higher tax bracket, you may want to reconsider your options.

Understanding these CD basics should help young investors find the right one for them. Or, they may decide it's not the right place for their money. While CDs can be an excellent place to grow your money, other alternatives -- like high-yield savings accounts -- offer similar benefits without tying up your cash.