What Is an Indexed CD?
An indexed certificate of deposit (sometimes called a market-linked, equity-linked, or market-indexed CD) is a type of CD that’s based on either a market index, a basket of equities, or a combination of the two. Indexed CDs usually have longer terms than traditional CDs. Similar to all other CDs, indexed CDs are FDIC-insured up to the legal limit of $250,000.
How Do Indexed CDs Work?
An indexed CD’s return is defined by the performance of its index and by its participation in that performance. Also, indexed CDs are usually subject to an interest cap, which limits the return. This protects the CD issuer from unusual gains in the index.
As with conventional CDs, there are penalties for cashing out an indexed CD before the agreed upon timeframe. However, indexed CDs can be redeemed or “called” by the issuing bank before the maturity date; the call price determines how much you earn in the event the bank redeems your CD.
How to Calculate Your Return from an Indexed CD
There are several ways to calculate an indexed CD’s performance:
- Participation rate. Let’s say an index sees a gain of 10% and the CD has a participation rate of 90%. The indexed CD earns 9%, or 90% of 10%. It is possible for the participation rate to exceed 100%.
- Point to point. The starting point is the value of the index when the CD is issued. The second point is the value of the index on a date right before its maturity date. The difference between these two numbers, or a percentage of that difference, will indicate the CD’s return.
- Average method. This takes the average of different values of the index. These values can be pulled from several different dates, or points, throughout the CD’s term.
Indexed CD Pros and Cons
Pros
- Indexed CDs usually pay higher rates than conventional CDs.
- Indexed CDs still offer the same FDIC insurance protection for purchasers, and can provide an easy means for bank customers with substantial assets to keep all of their CD money under the safety of the FDIC umbrella.
- Indexed CDs offer a safe method of investing in the market that does not require investors to defer their money until retirement like indexed annuities.
Cons
- Indexed CDs contain call features that allow the issuer to recall them at a certain price or timeframe.
- Cashing in the indexed CD early can incur severe withdrawal penalties.
- Many indexed CDs require a high initial investment, such as $25,000 or even as much as $100,000.
Is an Indexed CD Right for You?
Despite the drawbacks, there may still be potential upside in investing in a CD that is attached to market rates. Check out our updated list to see which bank is offering the best value in CDs right now.
