At first glance it sounds like a good deal offering diversification, market-based returns and protection of principal.

With the average non- jumbo traditional five-year CD paying just 1. For more, see Index-Linked Certificates of Deposit: Upside Potential, Low Risk. Unfortunately, there are caveats.

According to the Wall Street Journal, after fees, limits and other factors come into play, market-linked CDs often underperform conventional CDs. Furthermore, roughly a quarter of them paid no return at all. Although market-linked CDs can provide better returns than traditional CDs, you should only consider such a product if you fully understand and account for the potential downside.

Here are six potential pitfalls. If you need to cash out your CD before it matures , you may end up paying a stiff penalty. The penalty could cancel out any interest earned and in some cases even cause a loss of principal, according to the Securities and Exchange Commission SEC.

Even though your CD is linked to the market, returns on it are considered interest , not capital gains. Furthermore, interest must be declared annually, even when it is only paid at maturity.

This complicates owning a market-linked CD. Consider holding your market-linked CD in a tax-deferred account, such as an IRA, to avoid paying those annual taxes. If the stock market rises substantially for the duration of your CD, you will not receive full benefit of that increase. The cap can be in the form of a percentage of any increase or up to a specified cap limit. Some market-linked CDs have a call feature. This allows the issuing institution typically a bank to redeem the CD before it matures.

Your interest is determined by the call price, and it might be less than it would be if the CD were held to maturity.

The issuer is not obligated to call a market-linked CD. Generally speaking, the investment will be called when it is to the advantage of the issuer to do so.

Your Guide to Market-Linked CDs | GOBankingRates

If your investment is called, you may or may not be able to reinvest the proceeds at the same yield. For more, see Callable CDs: Check the Fine Print. There are typically no dividends with a market-linked CD, so dividend reinvestment is likely an option as it would be with regular stocks, mutual funds or other types of investments.

Series I Savings Bonds vs the stock market: US Savings Bonds

For some people, the lack of dividend reinvestment is a significant downside. For others, it is less important given the principal protection and, in many cases, guaranteed return. In the event your market-linked CD does have a guaranteed return and the market goes down, the net return may be less than you'd have received from a conventional CD.

Keep in mind that some market-linked CDs pay no guaranteed return at all. If you are invested in such a CD and the market is depressed during the term of your investment, you may actually receive no return at all — leaving you only with your original principal. The main advantage of a market-linked CD is exposure to the stock market without risk of losing your initial principal. As has been noted, however, even principal can be at risk under certain circumstances.

You should also take note of any fees, especially those that occur on the front end. As with all important financial decisions, meet with a trusted financial advisor to discuss the appropriateness of this product for you. Dictionary Term Of The Day. A measure of what it costs an investment company to operate a mutual fund.

Latest Videos PeerStreet Offers New Way to Bet on Housing New to Buying Bitcoin? This Mistake Could Cost You Guides Stock Basics Economics Basics Options Basics Exam Prep Series 7 Exam CFA Level 1 Series 65 Exam. Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education. Market-Linked CDs Often Underperform Unfortunately, there are caveats. Watch for These Risks 1. Penalties for Early Cash Out If you need to cash out your CD before it matures , you may end up paying a stiff penalty.

Returns Taxable as Interest Even though your CD is linked to the market, returns on it are considered interest , not capital gains. Upside Potential Capped If the stock market rises substantially for the duration of your CD, you will not receive full benefit of that increase. Lack of Dividends There are typically no dividends with a market-linked CD, so dividend reinvestment is likely an option as it would be with regular stocks, mutual funds or other types of investments.

Depressed Market Hurts Returns In the event your market-linked CD does have a guaranteed return and the market goes down, the net return may be less than you'd have received from a conventional CD. The Bottom Line The main advantage of a market-linked CD is exposure to the stock market without risk of losing your initial principal.

Certificates of deposit promise stable income in any market, but do they deliver? Certificates of deposit might not seem like a good place to keep your money when interest rates are low, but they do offer security and stability.

And with laddering and studying promotional A CD Ladder allows you to stagger your investments and take advantage of higher interest rates. Learn how to determine whether the money invested in certificates of deposit CDs can keep pace with the rate of inflation and how you measure inflation. Explore the various options available with certificates of deposit and discover how to find the most lucrative rates for CDs are FDIC insured, so they do not lose face value, though broker-issued CD accounts do carry risks.

6 Reasons to Beware of Market-Linked CDs | Investopedia

An expense ratio is determined through an annual A hybrid of debt and equity financing that is typically used to finance the expansion of existing companies. A period of time in which all factors of production and costs are variable. In the long run, firms are able to adjust all A legal agreement created by the courts between two parties who did not have a previous obligation to each other.

A macroeconomic theory to explain the cause-and-effect relationship between rising wages and rising prices, or inflation. A statistical technique used to measure and quantify the level of financial risk within a firm or investment portfolio over No thanks, I prefer not making money.

Content Library Articles Terms Videos Guides Slideshows FAQs Calculators Chart Advisor Stock Analysis Stock Simulator FXtrader Exam Prep Quizzer Net Worth Calculator. Work With Investopedia About Us Advertise With Us Write For Us Contact Us Careers. Get Free Newsletters Newsletters.

All Rights Reserved Terms Of Use Privacy Policy.