What is a zero-coupon CD?

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If you’re looking for ways to diversify your portfolio, you might consider zero-coupon CDs. There are some tax consequences you need to think about, but zero-coupon CDs can earn higher yields than other types of certificates of deposit. Here’s everything you need to know about zero-coupon CDs.

What is a zero-coupon CD?

To understand zero-coupon CDs, you first need to know how traditional CDs work. A conventional CD comes with an interest rate and term limit you agree to in advance. Any interest that accrues is usually paid out on a monthly basis.

In comparison, zero-coupon CDs are purchased at a lower price and you receive the interest payment at the CD’s maturity date. So with a zero-coupon CD, you wait longer to receive the interest payments, but your returns could be higher than if you bought a conventional CD.

How to invest in a zero-coupon CD

Zero-coupon CDs are typically purchased through brokerage firms. Banks can sell them, too. You will buy the CD at a discounted rate and won’t receive any payments until it reaches maturity.

Let’s say you buy a 5-year, $100,000 zero-coupon CD at the discounted price of $88,000. You wouldn’t receive any interest payments over the course of the term, but you would receive the $100,000 face value when the CD matures in addition to the accrued interest.

[COMPARE: Best 5-year CD rates]

Pros and cons of zero-coupon CDs

There are advantages and disadvantages to every financial decision and zero-coupon CDs are no exception. Here are some of the pros and cons you should consider before investing in zero-coupon CDs.

Pros

Earn a discounted rate

One of the most significant advantages of a zero-coupon CD is that you can earn deeply discounted rates. This discounted rate gives you the potential to earn higher returns than what other CDs offer since you didn’t pay for the full value of the original investment.

Low-risk savings option

You may like zero-coupon CDs because they are a low-risk savings option. Your return is guaranteed over a certain period of time as long as you don’t withdraw the money early. This could be an advantage if interest rates drop over the life of the CD.

A straightforward option

Professor and certified financial planner Brandon Renfro says zero-coupon CDs are a good option for savers who have longer-term savings goals. “You purchase a zero-coupon CD for a lower price and collect the larger maturity value at the end of the CD’s term,”  Renfro says. “That’s pretty straightforward and makes it very easy to plan for savings goals.”

Cons

No recurring income

Since you don’t earn any money until the CD reaches maturity, zero-coupon CDs don’t provide any recurring income. For that reason, Jonathan Bednar II, CFP,  wealth adviser and partner at Paradigm Wealth Partners, cautions that zero-coupon CDs are not a good option for individuals seeking to earn an income with their investments.

Can be callable

If you decide to buy a zero-coupon CD, you need to make sure your CD isn’t callable. Callable CDs allow issuers the option to redeem the CD before it reaches full maturity.

Taxes on interest that hasn’t been received

The biggest disadvantage of a zero-coupon CD is that you will have to pay taxes on the accrued interest even though you haven’t received it yet. As Renfro sees it, anyone looking to invest in a zero-coupon CD needs to plan for the phantom income it gives you along the way. The CD doesn’t pay out any interest until maturity, but it’s still income you earned and have to pay taxes on; therefore, this is something you will need to plan for every year.

Bottom line

Zero-coupon CDs are best suited for anyone that is looking for a safe, longer-term investment (such as buying a house). You won’t earn any recurring income, but you will have to pay taxes on the interest that accrues in the meantime. Your returns, however, could be higher than what you would get with a regular CD.

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