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A zero-coupon certificate of deposit is a CD that doesn't pay interest right away. It's bought at a discount instead. When the CD matures, you'll receive the face value—which is equal to your initial investment plus interest. Zero-coupon CDs are structured differently than traditional CDs, but they can deliver potentially higher returns. Like any investment, there are some trade-offs to consider. Here's how a zero-coupon CD works so you can decide if it's right for your financial portfolio.
How Does a Zero-Coupon CD Work?
Traditional CDs typically require a minimum opening deposit. Your money is then locked into the CD for the duration of the account term, which can range anywhere from one month to five years. When the term ends, you'll get back your initial deposit plus interest. The main drawback is that tapping your funds ahead of the maturity date usually triggers an early withdrawal penalty. Annual percentage yields (APYs) vary, but some CDs currently have rates that exceed 5.5%.
With a traditional CD, compound interest is added to the account at regular intervals. This may be daily, monthly, quarterly or annually. A zero-coupon CD doesn't pay out interest until it reaches maturity. You buy it for a price that's below its face value. When the term ends, you'll get that money back, along with interest.
Another important distinction is that you cannot withdraw money from a zero-coupon CD. The only way to access these funds is to work with a broker to sell the CD on the secondary market. You may have to wait for a buyer, and there's no guarantee that you'll recoup your investment.
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Zero-Coupon CD Example
You can purchase a zero-coupon CD through brokerage firms and banks. Let's say you find one with a face value of $8,000. You buy it for $6,400, which is a 20% discount. The maturity term is five years. When that period ends, you'll receive a payment of $8,000. That's a return of $1,600.
You might realize even greater gains if you invest a substantial amount of money—and are willing to part with it for an extended period of time. For example, let's assume you purchase a $30,000 zero-coupon CD with a five-year term for $20,000. That works out to a $10,000 return on investment.
A zero-coupon CD can be a good investment choice if you don't mind giving up access to your money for the length of the maturity period. These types of CDs reward patient investors who take the long view. If liquidity is important to you, however, a zero-coupon CD might feel restrictive.
What Are the Benefits of Zero-Coupon CDs?
Pros
- Potentially higher returns when compared to other CDs: Even with a high-yield CD, gains may lag behind a zero-coupon CD. That makes it an attractive investment option.
- Low risk: Zero-coupon CDs purchased through banks are FDIC-insured for up to $250,000. If you go through a brokerage firm, the Securities Investor Protection Corporation (SIPC) offers similar coverage. Returns are also guaranteed. That makes zero-coupon CDs very safe investments.
Cons
- Lack of liquidity: In the event of a financial emergency, you could pay an early withdrawal fee and pull money from a traditional CD. That's not possible with a zero-coupon CD. The only way to free up your cash is to sell the CD early.
- Tax liability: You won't receive an interest payment until a zero-coupon CD matures, but you're still responsible for paying taxes on interest that accrues annually. CD interest is considered income in the eyes of the IRS.
How to Choose the Right CD for You
Zero-coupon CDs have their advantages, but they may not be for everyone. You'll want to consider the purchase price, face value and maturity date to determine if a zero-coupon CD is a good investment. We've already touched on traditional CDs, but here's an overview of other types of CDs so you can decide which might be right for you:
- No-penalty CDs: These allow you to withdraw funds before the maturity date without penalty, though APYs tend to be lower than traditional CDs.
- High-yield CDs: Also known as jumbo CDs, these accounts typically offer higher interest rates in exchange for a much larger opening deposit—usually to the tune of $100,000 or more.
- Bump-up CDs: If interest rates rise after you've opened a bump-up CD, you can increase your rate to the current market rate. There may be limits on how many times you can do this.
- Step-up CDs: This works like a bump-up CD except that rate increases happen automatically at periodic intervals. That may be annually or every six months. However, initial interest rates tend to be lower when compared to traditional CDs.
- IRA CDs: This is a CD that's invested for retirement. You can open one through an individual retirement account (IRA), which offers unique tax benefits.
The Bottom Line
A zero-coupon CD could be a nice addition to your investment portfolio. They can generate above-average returns, though liquidity is limited and you'll have to pay taxes on accruing interest. Your unique financial situation will determine whether a zero-coupon CD is right for you.
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