What is an index-linked CD?

Yahoo

4 hours ago

Are you underwhelmed by today's certificate of deposit (CD) interest rates? If so, you might be interested in a lesser-known product called an index-linked certificate of deposit (ILCD).
With ILDCs, you can potentially earn better returns than with a regular CD since your interest is tied to the performance of an index, such as the S&P 500 or Nasdaq 100. However, if the index performs poorly, you could just as easily earn $0.
So, how do index-linked CDs work, and are they worth it? Here's what you need to know.
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An index-linked CD (also called a market-linked or equity-linked CD) is a type of CD that ties the amount of interest you earn to the performance of a specific index. So, unlike traditional CDs, you don't earn a fixed rate of return. In fact, there's a chance you won't earn anything at all if the index performs poorly.
Instead of a guaranteed rate of return, ILCDs earn interest when the index increases, decreases, or stays within a set range. The specific terms depend on the account.
However, even if the index shifts in the direction you want, your earnings can still be underwhelming due to the other terms associated with these products. Here are some of the common ILCD terms that reduce how much you can earn:
Interest caps: An interest cap sets a maximum percentage of interest you can earn per year, regardless of how well the market performs.
Participation caps: Also known as a participation rate, participation caps limit your interest to a set percentage of the change in the index. So if the index increases by 5%, for example, and your cap is 80%, your return will be 4% (that's 80% of 5%).
Averaging: With averaging, the CD issuer bases your returns on the average index performance over a set period of time, instead of the closing performance.
Calls: If your ILCD is a callable CD, the issuer has the right to close the account early, which means you have less time to earn interest.
Index-linked CDs are available through a limited number of banks and brokers, usually with five-year minimum terms.
An ILCD is essentially a hybrid between a CD and stock market investing: You deposit your money for a set period of time, like you would with a traditional CD, but your returns are based on market performance rather than a fixed rate.
The main upside to ILCDs is that, unless you make an early withdrawal, there's no risk of losing the money you deposit. However, ILCDs lack the main benefits you get from both investing in CDs and the stock market.
Unlike traditional CDs, for example, you have no guarantee of earning a single dollar in interest. Plus, the various rate caps and complicated interest calculations keep you from earning as much as you would by investing in other market-linked indexes, including many mutual funds.
According to Suze Orman, index-linked CDs make "absolutely no sense."
It's hard to pinpoint a scenario where ILCDs are worth investing in, especially considering that you might leave your money on deposit for five years or more, and end up with nothing to show for it.
Even worse, you could end up losing money in your CD. For example, let's say you go a couple of years without earning any returns, and then decide to make a withdrawal before maturity because you need the money for an emergency, or you just want to invest elsewhere. In this case, you'll incur an early withdrawal penalty, which will be subtracted from your original deposit amount.
In short, it's not a good idea to open an ILCD unless you're okay with the possibility of earning 0% returns, and potentially even losing some money.
Read more: Is paying a CD early withdrawal penalty ever worth it?
Whether you're looking for the benefits of a CD or the benefits of investing, you're more likely to find what you want elsewhere. There are plenty of good alternatives to index-linked CDs, but the best one for you depends on your goals.
If your goal is to protect your deposits and earn a competitive interest rate, you may want to consider a high-yield savings account (HYSA). These accounts pay as much as 4% APY. Plus, you can make a withdrawal from your account at any time with no penalties. The downside is that HYSA rates can change at any time, so your account may earn less when interest rates drop.
If you have money you want to set aside for at least a few months, and your goal is to maximize interest on that money, go with a fixed income investment, such as a traditional CD or Treasury bill. These investments guarantee your return for the entire term, so you can lock in a competitive rate for several months or years.
For those who want to invest for the long term, consider a mutual fund. If you want something similar to an ILCD, look for an index mutual fund, since these accounts track specific indexes.
Unlike with ILCDs, there are no interest caps on your returns when you invest in a mutual fund. As an added benefit, the taxes on your returns (capital gains taxes) may be significantly lower than the taxes on ILCDs, and you don't have to pay them until you sell or trade.
Alternatively, you might put the money in your retirement account, since your account likely includes a mutual fund already.
Read more: CD vs. mutual fund: Which is a better investment?