Equity-Linked Certificates of Deposit are Not What They Seem
Low CD rates have forced people to look elsewhere for higher returns. Equity-linked certificates of deposit offer the potential for higher returns. The rate of return on these types of CD accounts are linked to the performance of a stock market index, like the S&P 500 or Dow Jones Industrial Average (DJIA).
Equity-linked CDs are also FDIC insured for up to $250,000, the same as regular bank certificates of deposit. Equity-linked CDs have been around for about 20 years and most big banks offer them as an investment. On the surface, these CD accounts seem very attractive. Your principal investment is 100 percent secure while you earn higher rates than what traditional CD accounts are offering these days.
Equity-Linked CDs Rate of Return is Different from the Rate of Return on the Index
There are pitfalls in investing in equity-linked CDs. The biggest pitfall is that the return you eventually earn on the account won't be the same as the return on the index that the account is linked to. For example, if the S&P 500 had an annual return of 10 percent for the next 5 years, you would think an S&P 500 equity-linked CD would also have a return of 10 percent each year. Unfortunately, that isn't the case because banks offering these types of CDs use a method of pricing the index on a certain number of days of the year. The closing index price on those days determines the rate that the investment receives, which makes the return lower than the actual annual return on the index.
How Do Banks Make Money from Offering Equity-Linked CDs?
Banks that offer these CDs need some way of making money off of them, and the money they earn is the difference in the rate of return in the index and the return the CD holder is paid. Many people are surprised to learn this after the fact just because the disclosures on these investments are rather long and complex.
You might think you're still interested in equity-linked CDs because the returns can be higher than traditional bank CD rates. You might also think this is a good way to earn more income by receiving higher interest payments. You will have to wait until maturity to receive any interest payments or dividend payments.
Equity-linked CDs also have long terms, usually between 4 years and 6 years, which can be a problem for investors if they need their money sooner. With a traditional CD account, if an investor wanted access to some or all of their principal they would have to forfeit some or all of the interest earned.
With an equity-linked CD, if an investor wants access to principal they have to try and sell the CD account in the open market. Selling isn't as easy as selling stocks because these investments are not traded on any exchange. You might find it impossible to sell an equity-linked CD before maturity.
Fees and Commissions
There are fees and commissions that have to also be paid by investors of equity-linked CDs. Below are the fees and commissions in the JPMorgan Chase Bank disclosure (link above).
Before investing in equity-linked CDs, be sure to know what you're getting into. Take the time to completely read the disclosures and fully understand them before you invest. A good place to start is this summary on equity-linked CDs by the Security and Exchange Commission (SEC).
You can use our rate tables to find the best traditional CD rates here: CDRates.MonitorBankRates.com.