Indexed CDs are a complex way to save
With traditional certificates of deposit paying record low returns, banks are touting indexed CDs as a way to score a bigger return on your money.
But the high-pressure sales pitches typically gloss over the complex rules and high fees that can dramatically reduce what you'll actually make.
Despite the claims that you can earn 4% or more, and that your principal is federally insured just like a regular certificate or savings account, you can still end up losing money.
Indexed or market-linked CDs are often tied to a stock market index like the S&P 500, although it can also be dependent on everything from commodity prices to Treasury bill rates.
If the index is higher on the maturity date than on the purchase date, you make money.
If it's not, you earn nothing.
Indexed CDs have become a favorite product of the stockbrokers that are now in many bank branches.
Their job is to sell investments that generate more revenue than traditional deposit products.
Indeed, this investment isn't usually listed online like regular certificates. To buy one you must go in, meet with a broker and listen to the sales pitch.
They're promoted as a safe way to benefit from a rising market without risking any losses if the market declines because the principal is FDIC-insured.
That sounds pretty good to millions of savers who have sworn off the stock market but are horrified by the paltry interest rates being offered on traditional deposit accounts.
Most indexed CDs are offered in terms of six months to five years with minimum deposits ranging from $500 to $20,000.
But unlike a regular certificate, you can't buy an indexed CD anytime you want. You have to wait until a specific deal is announced and then buy in before a specific closing date.
Savers can have as little as two weeks to digest a 30- or 40-page prospectus loaded with fine print and figure out exactly what they're buying.
The first thing anyone considering this product needs to find is the up-front commission, which can cost as much as 5% of your investment.
Then you need to check what's called the participation rate. It specifies the extent to which your return correlates to the appreciation of your index and typically ranges from 75% to 100%.
If, for example, you choose a 1-year term with a participation rate of 75%, and the index rises 50%, you're return would be an astronomical 37.5%.
That's amazing, right?
Wrong. The catch is that many indexed CDs have a cap or maximum rate of return, and it ranges from 6% to 10% per year.
Going back to our example, that one-year certificate with a 75% participation rate and 50% increase in the tracking index would probably limit your return to much less than 37.5%.
It is likely that you won't earn a dime if the index falls.
Remember, it doesn't matter how high the index might go throughout the term. Everything depends on whether the index is up or down on the maturity date.
Theoretically, as long as you hold until maturity, you'll walk away with your entire principal. But those fees you paid up front can bite you in the end.
If, for example, you buy a $10,000 certificate with a 3% commission, that $300 fee will be automatically be deducted from your principal, leaving you with an investment of $9,700.
In that case, even if you make nothing, and even though your principal is guaranteed, you could still wind up losing 3% of your savings.
In general, the higher the participation rate and maximum return, the bigger the commission will be.
We tend to favor indexed CDs with lower participation rates and maximum returns but no commission.
If you haven't seen enough red flags yet:
- There are substantial penalties if you cash in before the maturity date -- penalties that will reduce your principal. So don't commit any funds that you might need between now and then.
- Watch out for CDs that promote the chance to make early withdrawals. They usually come with very high fees and other costs that can be buried deep in the prospectus in tiny writing.
- Some banks and brokers reserve the right to "call" before maturity. In a case like that, you'll almost certainly earn less than if the seller had allowed you to hold to maturity.
- Each seller imposes its own unique set of rules and fees. That makes buying an indexed CD more like buying an annuity than a traditional certificate.
One final thought.
You'll probably have fewer nasty surprises if you buy one from a broker you work with on a regular basis and who has an incentive to protect a long-standing relationship.
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