Traditionally, a certificate of deposit (CD) is a low risk and relatively low-return investment for extra cash you have but you don't need for months or years. If you leave the money with a financial institutions for the agreed term (i.e. 6 months, 12 months or longer), you will get paid a slightly higher interests than say, leaving your money in a regular savings or checking account. When the term is up, the bank or financial institution will return your principal and interests. Therefore, CDs is usually considered one of the safest investments.
Financial institutions, such as banks, brokerages and insurance companies, have rolled out a new type of CDs. It came with many variation of names: market-linked CD, equity-linked, indexed CDs or structured CDs. This type of CDs has been around since 1980s but financial institutions have been marketing it aggressively in recent years. The biggest selling point of this type of CDs is that it has the potential to earn more than traditional, fixed-rate CDs because the return is linked to the future performance of a market index that could include stocks, bonds, foreign currency or other assets. At the same time, it promised to offer downside protection so if the index that CD is linked tanked, you as investor should at least get your principal back.
Not so fast.
Before you are allured by the upside potential of such CDs, you have to know the following:
High fees and commissions: everyone involved in the sales chain of this type of CDs-a whole sale broker, a financial adviser etc get higher commission (could be up to 3%) for selling it than a traditional CDs. After offsetting fees and commissions, your return may not be as attractive as you've been promised.
Limited upside potential: this type of CDs usually comes with a cap on the rate of return you can get. For example, if the CD limits your upside cap at 6%, it means that the most return you can get is 6% even if the underlying index the CD is linked to could have rose 10%.
Complexity: how your return is calculated is complicated and difficult for many average investors to understand.
Early withdrawal penalty: just like regularly CDs, you will have to pay a financial penalty if you want to withdraw your fund from the CD prior to its mature date.
Be aware, this type of CDs is not as low risk as traditional CDs. So don't let their name fool you. If you don't understand , do not invest in it.