There are only so many low-risk saving options that keep your money safe and also provide a nice return. High-yield savings accounts and certificates of deposit (CDs) are the most common ways to grow your funds without worrying about losing principal. Meanwhile, the stock market offers the possibility of higher returns in exchange for much greater risk. What if there were a way to access the richer returns of public markets together with the low-risk security of a CD?
Market-linked CDs are designed to address this very need. With these types of CDs, your principal investment gets the security of a traditional CD as well as the possibility of extra gains when the stock market outperforms. Sounds great, right? Beware, market-linked CDs are somewhat difficult to understand. Read on to learn all the details.
Also known as index-linked or equity-linked CDs, market-linked CDs are certificates of deposit with variable interest rates, determined by the stock market. While a conventional CD offers a set interest rate for the term of the deposit, a market-linked CD‚Äôs rate of return fluctuates over its term.
The rate of return on a market-linked CD is dictated by the performance of a stock index like the S&P 500, by a basket of individual stocks, or by a combination of indices and stocks. If the underlying index or stocks perform well, the amount you make from these CDs rises. But if they do poorly, you make less ‚ÄĒ and in some cases your rate of return can go to zero.
‚ÄúMarket-linked CDs are getting more interest because of volatile markets,‚ÄĚ says Tom Balcom, founder of 1650 Wealth Management, a Florida-based financial advisor. ‚ÄúIt's a product that at certain times is more desirable for investors.‚ÄĚ
These CDs are usually offered for a term of at least five years, with some terms even going out to 20 years. Similar to a conventional CD, investors will be charged a penalty for early withdrawals. However, market-linked CDs are ‚Äúcallable,‚ÄĚ which means the issuing bank can choose to redeem it before its maturity date.
It can be challenging to understand the total rate of return available from a market-linked CD. While the amount you earn is determined by the performance of an underlying index or group of stocks, there are two limitations on your rate of return: the participation rate and the interest rate cap.
As we all know, stock markets go down as well as up. Losses in indices or stocks on which a market-rate CD are based do not touch the principal investment. However, stock losses mean that your rate of return can be zero. In cases like this, you would have lost out on the opportunity to invest the same money in another investment, like a conventional fixed-rate CD, with a guaranteed return over its term.
Your total return on a market-linked CD is calculated using one of two methods. The point-to-point method looks at the starting value of the underlying index or basket of stocks when the CD is issued and their ending value at maturity. The difference between the two numbers will indicate your return rate ‚ÄĒ modified by the participation rate and any interest rate cap. The average method averages the value of the index or basket of stocks on regular dates throughout the term of the CD¬† ‚ÄĒ also modified by the participation rate and any interest rate cap.
With so many moving parts, these CDs are an interesting investment product ‚ÄĒ one with several pros and cons.
Investors are often interested in market-linked CDs because of their potential to deliver higher returns than conventional CDs. While this is true if the market is performing well, a down market could tie up your money with little or no return.
However, if you want to take a chance on a higher return than a conventional CD, a market-linked CD might be worth the investment. ‚ÄúIf you're a Nervous Nelly about the market and say, ‚ÄėOh, I don't want to invest in the market because I could lose money,‚Äô this is a good investment tool for you because it provides you with some exposure to the market, but not the downside exposure,‚ÄĚ says Balcom.
Conventional CDs and market-linked CDs are just two of your CD options. Another product is a jumbo CD, which requires an initial deposit of $100,000 and offers a higher rate of return than a conventional CD. A no-penalty CD allows you to access your money before the end of the term without penalty. A bump-up CD lets you switch your CD for one offering a higher rate if it comes available during your investment period. And a brokered CD is offered by a middleman, such as a stock broker or financial advisor who buys CDs in bulk from banks, negotiating higher rates.
Market-linked CDs offer the principal protection of a conventional CD with the potential of higher returns. Unfortunately, those returns aren‚Äôt guaranteed. Choosing this product comes down to your tolerance for risk, says Balcom.
‚ÄúAnybody that wants a higher return than offered with bank CDs, this would be a better product for them,‚ÄĚ says Balcom. ‚ÄúSomebody who says, ‚ÄėI'm worried about the market‚Äô and ‚ÄėWe're in near-all-time highs; I don't want to lose money,‚Äô‚Äď if they use those terms or phrases ‚Äď it‚Äôs possible this is a good product for those individuals.‚ÄĚ
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