Are you dissatisfied with today's certificate of deposit (CD) interest rates? If so, you may be interested in a lesser-known product called an index-linked certificate of deposit (ILCD). With ILCDs, 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.
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. Unlike traditional CDs, you don't earn a fixed rate of return. Instead, your interest is based on the change in the index over a set period of time. The specific terms depend on the account, but here are some common ILCD terms that can reduce your earnings:
- 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.
- 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.
Pros and cons of an index-linked CD
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 if you decide to make an early withdrawal before maturity due to an emergency or other reasons. 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.
