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Indexed CDs offer safety, but there's still risk

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Who is offering them?
Indexed CDs vary considerably. First State Bank in Gothenburg, Neb., recently closed an issue of 4-1/4 year non-callable indexed CDs with no cap or floors and a 4 percent minimum interest rate for the full term.

Minnesota-based Merchants Bank National Association has just launched two ICDs in the Winona branch, both linked to the Dow Jones industrial average: a three-year product with a guaranteed 1 percent annual percentage yield, or APY, and a 75-percent participation rate; and a five-year product with 85 percent participation. According to Sue Hovell, director of sales and marketing at Merchants, these products are not suitable for everyone, but may be right for depositors "who don't like to lose money but still would enjoy a little upside."

Hovell says that in light of current uncertain economic conditions, Merchants expects this product might appeal to individuals who feel jittery about the markets.

Read the fine print
"There is no investment decision that does not involve some sort of risk," says Maloney Stifler, adding that as with any investment, a consumer interested in indexed CDs should "do a lot of digging and read the fine print."

Potential risks of indexed CDs:
Lost opportunity. The typical consumer for a traditional CD wants safety of principal plus a guaranteed rate of interest, but depending on the terms of the indexed CD, you might not earn any interest at all. "If the market doesn't do well, the consumer might end up with just the principal and no return," says Maloney Stifler. "That is lost opportunity cost."
Liquidity. Like their traditional counterparts, indexed CDs must be held until maturity or the consumer may be hit with penalties. Since most indexed CDs are typically offered in greater than three-year maturities, the depositor must be certain that these funds will not be needed in the short term.
Participation rates or caps. While ICDs claim to offer returns of the corresponding index, the actual return that the depositor receives may be capped at a certain percentage depending on the issuer. Sherzan recommends looking at the participation rate. "If it is capped, it can negatively affect your investment return."
Taxes. If the money you deposit into an indexed CD is taxable, you will owe taxes annually on the earnings, even if you don't receive the actual interest until maturity, so you may have to come up with funds to pay the tax bill out of another pool of assets. Hovell stresses that these may not be appropriate for retirement accounts held by individuals who are nearing or past age 70, as liquidity restrictions prevent withdrawal of funds to pay the minimum required distribution tax to the IRS. Additionally, says Maloney Stifler, "This is going to be taxed as interest income, a higher rate than a capital gain."
Bank credibility. The FDIC's DiNuzzo says that "as with any deposit, it's advisable to make sure you're dealing with a reputable institution."

Consider all options
Depending on your perspective, an indexed CD is an equity investment with downside protection or a CD with potential risks. According to Maloney Stifler, "if you're looking for ways to manage downside risk, you should consider all the options to accomplish that goal."

Bankrate.com's corrections policy -- Posted: March 4, 2008
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