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Indexed CDs

Indexed CDs

"Risk Blocks" by jscreationzs on freedigitalphotos.net

I was surprised to arrive upon an interesting type of Certificate of Deposit while researching online. The normal CD is usually based upon a certain APR, compounded at a certain rate until maturity. These interesting CDs were called Indexed CDs and they provided exposure to an underlying index such as the stock market, currency market, or commodities market.

The particular one I ran into tracked a basket of precious metals. The prospectus was very transparent in the methodology that was used so I was very interested in it. The more I read, the more interested I got. In a nutshell, this was what they offered.

The Good

  • $10,000 minimum deposit
  • 5 year CD
  • FDIC insured up to FDIC limit
  • Principal is guaranteed if index doesn’t perform

Wow, I can get the same amount of money out that I put in even if the index performs badly? Are you serious? There is an instrument out there that gives me exposure to the volatile precious gold market with no downside risk? Sign me up, right? No.

You’ll notice I haven’t named the bank where I found this product. That is because I don’t want you to consider what they offer. If you search around Google, I am sure you’ll find it if you really want to take a chance. I dug really deep, because that is what I do before I commit money. Here are some issues that I had.

The Bad

  • Must pay taxes on “phantom income” every year
  • High opportunity cost risk
  • Banks time these offers strategically

The Ugly

Let me go into a bit more detail on the above list. At the end of every year, if the calculations show an increase in the index, you have to pay taxes on the difference just like in a regular CD. I’m not completely sure about how to get those tax dollars back if you break even at the end of 5 years and only get your principal back. Please ask a financial professional if you’re interested in this type of product.

Say you put your money in the account and at the end of 5 years nothing happens. You come out even and no money is lost. That’s where opportunity cost comes in. You could have put that same money in a 5 year CD for a fixed percentage and earned interest! Their minimum deposit is nothing to sneeze at and 5 years is a long time for your money to sit idle.

Here’s the last point that I want to make. Banking institutions are not stupid. They have departments that do risk analyses of their products before they offer them. This particular bank only offers select indexes at select times of the year. Besides risk analysis, banking institutions also have departments that monitor the markets and make informed judgments. Look at the state of the precious metals market right now and tell me if these bankers aren’t smart.

Categories: Banking
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