More to gain, less to lose, with indexed CDs
With rates on traditional CDs so low, why not take a chance on an indexed CD?
By taking a chance, we don't mean taking a chance with your principal.
That's still FDIC-insured.
We mean take a chance on how much you might -- or might not -- earn.
The return on indexed or market-linked CDs isn't fixed as it is with traditional CDs.
It's 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.
When traditional certificates of deposit are paying 3% or 4%, there's little reason to take that risk.
But when they're paying 2% or 1%, or even less, you've got a lot less to lose and a lot more to gain by taking a chance on indexed CDs.
Indexed CDs are typically offered by brokers and larger banks, but they can be found at some community banks.
Most indexed CDs are offered in terms of six months to five years, with minimum deposits ranging from $500 to $20,000.
How much you'll earn depends on how well your index performs and two other factors -- the participation rate and the maximum rate of return.
The participation rate specifies the extent to which your return correlates to the appreciation of your index. It generally ranges from 75% to 100%.
For example, if you buy a one-year CD with a participation rate of 75%, and the index your CD tracks rises 50%, you're return would be an astronomical 37.5%.
The catch is that many indexed CDs have a cap or maximum rate of return.
Those caps can range from 6% to 10% per year.
So, going back to our example, that one-year CD with a 75% participation rate and 50% increase in the tracking index would probably limit your return to much less than 37.5%.
The main risk is that you won't earn a dime if the index falls during the time you own your indexed CD.
And remember, it doesn't matter how high the index might go during the time you own the CD. Everything depends on whether the index is up or down on the maturity date.
As long as you hold the CD until maturity, you'll walk away with your entire principal.
Most banks and brokers routinely hold that principal in an FDIC-insured account (and you shouldn't buy an indexed CD from anyone who doesn't).
Fees are the only thing that can ding your principal.
Some sellers don't charge a commission. Others charge as much as 5% of the initial deposit.
For example, if you buy a $10,000 CD with a 3% commission, that $300 fee will be deducted automatically from your principal, leaving you with an investment of $9,700.
In that case, even if you make nothing on the CD, 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.
You'll have to weigh the potential gains and losses of each deal and find the balance you're comfortable with.
Regrettably, much of that decision can be summed up by the old Clint Eastwood line: "Do I feel lucky? Well, do ya, punk?"
A few final thoughts before you invest.
There are substantial penalties if you cash in an indexed CD before the maturity date -- penalties that will reduce your principal.
So don't commit any funds to an indexed CD 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 in their indexed CDs before maturity. In a case like that, you'll almost certainly earn less than if the seller had allowed you to hold the CD to maturity.
And finally, 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 CD.
You'll probably have fewer nasty surprises if you buy one from a bank or broker you work with on a regular basis and who has an incentive to protect a long-standing relationship.