Zero-coupon CDs: What they are and how they work

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If you’re looking for ways to diversify your financial portfolio, you might consider zero-coupon CDs. There are some tax implications you need to weigh, but zero-coupon CDs can earn higher yields than other types of certificates of deposit. Here’s what 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 on a monthly basis.

Zero-coupon CDs, in comparison, are purchased at a lower price and you receive the entire interest amount 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.
This type of deposit account gets its name “zero-coupon” since “coupon” refers to a periodic interest payment, and “zero” refers to the fact that it does not incorporate such payments.

How do zero-coupon CDs work?

You’ll pay a discounted price for a zero-coupon CD in exchange for not being paid interest throughout the term. You’ll receive the full face value of the CD, plus all the interest, once it matures.

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.

How to invest in a zero-coupon CD

Zero-coupon CDs are typically purchased through brokerage firms, though banks sell them too. Zero-coupon CDs are purchased at a discounted rate and no payments are made until the term ends.

Opening a zero-coupon CD is similar to a traditional CD. You can visit a bank branch or set up the account online, depending on the bank. You’ll be asked for some personal information and to name a beneficiary for the account. You’ll also need to fund the CD at the outset, and a minimum balance may be required.

Know the date when your zero-coupon CD will mature and what your options will be for collecting your principal and interest or renewing the CD.

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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 pros and cons to consider before investing in zero-coupon CDs.

Pros

Potential for higher return

One of the most significant advantages of a zero-coupon CD is that they are sold at a discounted price. You’ll potentially earn a higher return than what traditional CDs offer since you didn’t pay face value for the CD at the outset.

Low-risk savings option

Zero-coupon CDs are a low-risk savings option with a guaranteed return, as long as you don’t withdraw the money early. Including them in your portfolio could work to your advantage if you expect interest rates to drop during the duration of the CD.

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

Can be callable

If you decide to buy a zero-coupon CD, be sure it isn’t callable. Callable CDs allow issuers the option to redeem the CD before it reaches full maturity. A bank may decide to take back the CD early if interest rates drop, in which case you’ll only earn part of the interest. You’ll also have the hassle of finding a new place to invest the money.

Taxes on interest that hasn’t been received

The biggest disadvantage of a zero-coupon CD is you’ll have to pay taxes on the accrued interest each year 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 reported as income you earned and have to pay taxes on every year.

Bottom line

Zero-coupon CDs are best suited for consumers looking for a safe, longer-term investment. You won’t earn any recurring income, but you’ll 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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