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Retirement Savings: How Much Should I Save Each Month?What Is a Market-Linked CD?
A market-linked certificate of deposit (CD) is a financial product with returns tied to the performance of a specific market index, such as the S&P 500. Unlike a traditional CD, which pays a fixed interest rate, a market-linked CD earns a variable rate based on the performance of the linked index, which means you could earn higher returns. Here’s all you need to know about market-linked CDs.
How a market-linked CD works
A market-linked CD — sometimes called an index-linked CD — combines features of a traditional CD, such as a fixed term and principal protection, with the potential for higher returns.
Market-linked CDs “link” their performance to a market index, such as the S&P 500. As with a traditional CD, you must keep your money in a market-linked CD for a specific period of time, known as the CD term.
Because a market-linked CD is tied to a specific market index, it has the potential to outperform a traditional CD if the underlying market index does well. However, the opposite is also true: If the market declines, so could your CD earnings. You may not see any gain and will only get your initial investment back when the term is done.
As with a traditional CD, you must pay an early withdrawal penalty if you need to access the money in your market-linked CD before the term ends.
Market-linked CDs vs. traditional CDs
| Market-linked CD | Traditional CD |
| Earns a variable interest rate that depends on the performance of a specific market index | Earns a fixed interest rate |
| Guarantees the principal if held to maturity | Guarantees the principal |
| Typically sets terms from one to seven years | Typically sets terms from 3 months to 7 years |
How much can you earn with a market-linked CD?
The amount you can earn with a market-linked CD depends on its structure and how the underlying investments perform. Here are some ways a market-linked CD can be structured:
- Pays interest based on an increase or decrease in an index
- Pays interest if an index stays within a specific range
- Bases earnings on average changes in an index, quarterly or annually, during the CD’s term
Note that some market-linked CDs have a “participation rate.” The participation rate measures how much of the index’s upside performance, or increase in value, an investor will realize. For example, if the participation rate of your market-linked CD is 80% and the index rises by 10%, you’ll earn 8% of the index’s increase.
Make sure to read the fine print so you’ll know how your potential earnings will be calculated.
Market-linked CD pros and cons
PROS
- Federal Deposit Insurance Corp. (FDIC) insurance: Your CD’s principal amount is covered by FDIC insurance up to the standard limit of $250,000 per person, per insured bank for each ownership category.
- Principal protection: Even if the linked market index declines, your principal balance will remain intact if you hold the CD to maturity. However, an index decline may reduce your overall earnings.
- Higher returns than a traditional CD: Market-linked CDs offer the chance to earn a higher rate than traditional CDs, depending on market performance.
CONS
- Funds not easily accessible: As with traditional CDs, your funds are locked in for a set term, and you’ll need to pay an early withdrawal penalty to access your money sooner.
- Unpredictable returns: Because market-linked CDs are tied to a market index, returns can fluctuate, and you may only get your initial investment back.
- Tax implications: Market-linked CD earnings are taxed at ordinary income tax rates, which are higher than the capital gains tax rate.
How to open a market-linked CD
Here are the steps to opening a market-linked CD:
- Choose a financial institution. A good place to start is seeing whether your current bank or credit union offers market-linked CDs. You can also check brokerages, such as Fidelity. You’ll want to compare terms, fees and reputations across a few different financial institutions.
- Review the terms and conditions. Because market-linked CDs are complex financial products, carefully review the fine print before opening an account. Some key items to understand are the participation rate as well as account fees and early withdrawal penalties.
- Choose your term and deposit money. Many market-linked CD providers offer terms of up to seven years, and the minimum deposit will vary by provider.
Where to buy a market-linked CD
You can get a market-linked CD account through a bank, credit union or brokerage that offers these products. Keep in mind that some financial institutions require a minimum deposit to open a market-linked CD. The amount varies by provider but is generally at least $1,000.
Here are a few examples of places that offer a way to invest in market-linked CDs:
- Fidelity
- HSBC
- JPMorgan Chase Bank
Should you get a market-linked CD?
Whether you should get a market-linked CD depends on your financial circumstances.
Let’s say you need access to your money for a short-term goal, such as a down payment on a house or a car purchase. In that case, a short-term traditional CD or high-yield savings account may be a better fit.
On the other hand, if you want to participate in the market with the security of principal protection, a market-linked CD is worth considering.
Market-linked CD alternatives
If a market-linked CD isn’t right for you, consider one of these alternatives:
Bonds
Like CDs, bonds have different maturity dates and offer competitive rates. You can choose from many different types of bonds, including government bonds, such as Series EE bonds, corporate bonds, and bond funds, which may hold a mix of government and corporate bonds.
Traditional CDs
If you want to avoid market risk, a traditional CD may be a better choice. Traditional CDs offer a fixed interest rate for the entire term, so you’ll know exactly how much you’ll have to spend or roll over into a new CD once it reaches maturity.
High-yield savings accounts
If you’re looking to avoid market risks, a high-yield savings account allows for this while still earning a competitive rate. Keep in mind that high-yield savings accounts have variable interest rates, which makes their earnings trickier to predict than traditional CDs with fixed rates.
Frequently asked questions
Are market-linked CDs FDIC-insured?
Yes, market-linked CDs are generally covered by FDIC insurance up to $250,000 per depositor. One caveat: Only your principal balance is covered.
How are market-linked CDs taxed?
The interest you earn in a market-linked CD is taxed as ordinary income, typically in the year it’s earned — even if it’s not paid out to you. The taxation of market-linked CDs can be complicated, so it’s important to speak with a tax adviser about your situation. You also may be able to purchase a market-linked CD in a tax-advantaged account.
What are the risks of a market-linked CD?
The main risks of a market-linked CD are lack of liquidity and unpredictable returns. If you’re looking for more stability, a traditional CD or high-yield savings account may make more sense for you.