The Positives & Negatives of Index-Linked Certificates of Deposit
Index-linked certificates of deposit, first offered by banks in 1987, do not have stated interest rates. Your returns depend on the performance of a stock market index, such as the S&P 500. These CDs are more appealing than conventional CDs when interest rates are low. However, like any investment, index-linked CDs come with some risk if the index does not perform. If the index level drops after you purchase the CD, you could end up with zero earnings during the certificate term.
Index-linked CDs are dependent on stock market returns. This is both a potential positive and a possible negative. If the market performs well, you enjoy higher returns than a typical fixed-rate bank CD. Conversely, should the stock market experience declining prices, your indexed CD endures similar decreases, earning lower interest. With average maturities of from three to five years, index-linked CDs generate no benefits or risks from short-term market spikes, either up or down, since earnings are typically posted only once a year.
Since commercial banks offer these CDs, your account principal is FDIC-insured. Consequently, your investment amount is secure, unlike most investments, where your investment dollars are at risk. The FDIC insures up to $250,000 per depositor for the total of his account balances at individual banks. Unfortunately, the FDIC does not insure interest earned, but not yet posted to your CD. This is a negative that applies whether you have a regular or indexed CD.
Index-Linked CD Appeal
One appeal of index-linked CDs is that they offer returns on investment similar to stock market gains. This appeal is enhanced by the safety of the FDIC-insured principal at your bank. There are no such guarantees when you invest in the stock market. However, the positive appeal of index-linked CDs comes with two potential negatives. First, if the index decreases in value, your return on investment also declines, possibly all the way to zero. Second, banks often put restrictions on interest postings and penalty-free withdrawals, which could cost you money if you need emergency withdrawals.
Carefully weigh the potentially higher earnings on index-linked CDs against the potential for decreased -- even zero -- earnings if the index declines from its level at your CD purchase date. Evaluate the safety of your principal, a strong positive, against the potential alternative investment options, such as bonds, which also promise that your investment amount is safe and secure. Also consider tax implications: Your earnings are taxed in the year they are posted to your CD. If you want to shelter the earnings, use an index-linked CD in your IRA account, which is free from taxation until you begin to withdraw funds at retirement.
Banks offer index-linked CDs with participation rates that limit your earnings. This often confusing feature often accompanies index-linked CDs. For example, having an index-linked CD with an 80 percent participation rate means that if the linked index increases 12 percent, you only earn 9.6 percent (80 percent of the index increase). Participation rates less than 100 percent are positives for your bank, as they cap your earnings, but negatives for you and your index-linked CD balance.