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Certificates of deposit (CDs) are a tried-and-true investment that retirees and others often turn to when they want to preserve their money while earning at least a smidgen of interest.
These investment stalwarts serve as quiet guardians of your money rather than as risk-takers that could expose you to danger. Those traits are both their strength and their weakness.
Yes, the money in a CD is insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000 and guaranteed to give you the promised rate of return. But because of the low interest rates that CDs typically come with, they sometimes even struggle to keep up with inflation.
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In other words, the spending power of your money is often just holding steady rather than making gains.
What are market-linked CDs?
Fortunately, these reliable but low-return CDs have a cousin of sorts with significantly more upside: market-linked CDs. If you’re unfamiliar with them, an explanation is in order.
Market-linked CDs differ from traditional CDs in that they have a return on investment that’s connected to an underlying asset, which could be a group of stocks, an index (such as the Russell 2000) or a commodity (such as gold).
That means they offer a significantly higher upside than their traditional counterparts because their performance is tied to how well the market is doing and not to a set interest rate.
At the time of this writing, many traditional CDs are paying slightly under or slightly over 4%. In contrast, a market-linked CD can soar with the rest of the market during good times, although the issuer may place a cap on the CD’s value.
Generally, though, the growth potential of a market-linked CD is higher than that of a traditional CD. In a good year, that might be a 12% to 15% return.
Of course, we all know that good times aren’t constant in the market. In the worst of times, the market can drop precipitously.
To lessen the blow in such circumstances, market-linked CDs often come with a minimum guarantee, which limits how much their value can drop if the market takes a turn for the worse.
Length of investment
Another way in which traditional CDs and market-linked CDs differ is the length of time you hold them.
Although traditional CDs may have longer maturity dates, some can mature within a few months, giving you the option to cash in or roll them over in a short period.
With market-linked CDs, the minimum maturity term is one year, and for many, it’s several years.
In other words, they are not a particularly liquid investment; the money you put into them won’t be available to you during their term — unless you’re willing to pay a penalty for early withdrawal.
That means you need to think carefully about how long you feel comfortable tying up your money.
Typically, I would say three to five years is a good range, which most people can handle, assuming they have other funds stashed away that they can quickly access if needed.
With some market-linked CDs, you may be investing your money for up to 10 years, but I would steer clear of these. That’s a long time not to have access to your money.
Advantages and disadvantages
As with any investment, market-linked CDs come with advantages and disadvantages.
Some advantages include:
- Like traditional CDs, market-linked CDs are FDIC-insured for up to $250,000, giving you added confidence that your money is preserved
- You have the potential to reap higher returns — in some instances, much higher — than with a traditional CD
- Your principal is preserved, no matter what happens in the market
Some disadvantages include:
- The earnings cap limits how much you can make, while there is no limit to how much money you can earn if you invest in the market
- You may not make any money at all, ending up with the amount you initially invested
- Market-linked CDs are taxed as ordinary income rather than at the lower capital gains rate
As with many investments, a market-linked CD should comprise only a portion of your overall portfolio.
A financial professional can help you review your current investments, determine whether a market-linked CD might be suitable and discuss with you the advantages and disadvantages based on your individual situation.
For investors wanting to add more diversity to their investments and looking for a potentially solid return while limiting their risk, market-linked CDs can be an attractive alternative.
Ronnie Blair contributed to this article.
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