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Equity Linked Certificates of Deposit

Equity Linked Certificates of Deposit

CD rates are so low right now you might not even be staying ahead of the inflation rate on your CD investment. The highest CD rates on 5 year bank CD rates are less then 3.00% and more around the 2.00% range. If you want to stick to the safety of investing in certificates of deposit you might want to look into investing in a an equity-linked CD account.

Equity linked CD accounts are FDIC insured certificates of deposit that ties the rate of return to the performance of a stock index such as the S&P 500. This is unlike regular bank CD rates and credit union CD rates. Just as with regular CDs equity linked CD terms can vary but typically the term is five years. 

When you invest in these types of CDs the financial institution calculates your investment return based on the date that the CD account matures and it is also based on the terms of the CD contract.  You might not make any more than what payment is guaranteed in the contract. As with any investment you should understand the CD contract terms. You should also verify the finanical institution that you are thinking of investing with is reputable company.

The biggest benefit to an equity linked CD is your principal isn't at risk if the stock market goes down. The only thing you are risking is the CD interest that is paid to you.

The biggest negative is the liquity in these types of CDs. With a regular CD issued by a bank you just cash in the CD account early if you need access to your money. The only penalty you'll probably pay is some of the interest earned. With a equity linked CD you have to try and sell the CD in a secondary market.  There might not be any buyers or you might end up selling the CD for less than your principal investment.

You might not even be able to sell the CD. Many equity-linked CDs do not permit an early withdrawal of your investment without the consent of the institution you purchased the CD from.  There is no exception to the type of CDs held in either a traditional IRA account or a Coverdell Education Savings Account (CSA). 

There are also some equity-linked CDs allow for redemption only on pre-specified redemption dates. You may not be able to redeem your equity linked CD when you may want or need your money to be available. Which is why you really need to make sure what you're getting into.

If you can sell your CD in the open market before maturity, the CD account may be worth less than its purchase amount or face value.  The CD is subject to a number of variables, including stock market volatility and changes to the components of the linked index.  Again, your principal is only 100% safe if you hold the investment to the maturity date.

While you might not have the option of selling the CD before maturity the financial institution can force you to sell it back to them early. This is called a callable CD. If an equity linked CD is called, your  return may be less than the yield for which the CD would have earned had it been held to maturity.  Chances are if the CD is called rates have gone down and you probably won't be able to invest their funds at the same rate as the original CD.

Equity linked CDs are insured by the FDIC up to the amount permitted by law, $250,000 per account, per depositor.  FDIC insurance covers the principal of, and any guaranteed interest on up to $250,000. If you deposit a quarter mil, earn 5 grand in interest only $250,000 is guaranteed if the issuing institution fails.

An equity linked CD account return is calculated by averaging the closing price of the underlying index over a specific period of time. The financial institution may use an average based on the closing price of the S&P 500 every six months during the term of the CD.  This formula can have a negative or positive impact on your return.

With wild market swings like we just had where the S&P 500 was almost in bear market territory then jumpped 10% in a week you return can different than the market return.

There is also something called participation rates which determines how much of the index’s increase will be used to compute the interest calculation.  If the S&P 500 goes up 30 percent and the participation rate is 50%, you will get only a 15 percent return.

There can also be caps on how much you earn in a year. Say the markets go up 50 percent in a year, your return is subject to the participation rate which in this case is 50%, this knocks your return down to 25%. If the cap is 15% your return is only going to be 15%, not 25%. Again, your principal isn't at risk (as long as you hold until maturity) so a cap on your return isn't such a bad trade-off.

Author: Stacy Everest
October 13th, 2011