Zero-Coupon CDs: What Are They & How Do They Work?
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Summary:
Zero-coupon CDs are certificates of deposit purchased at a lower price with no monthly interest payments. Instead, the investor receives the CD at face value at the maturity date. While this kind of CD can be a great investment for the right person, zero-coupon CDs also come with some downsides to keep in mind.
If you’re looking for an easy and low-risk way to invest your money, consider investing in a certificate of deposit (CD). CDs are a way to earn interest on a lump sum of money for a set amount of time, but you can’t access that money during that time.
There is a wide variety of CDs you can choose from, and while most CDs have monthly interest payments, there is an exception to this rule: zero-coupon CDs. While other CDs have regular interest payments, zero-coupon CDs do not accrue interest. Because of this, a zero-coupon CD can usually be purchased at a discounted price and have the potential to bring in more money than a traditional CD would.
So why wouldn’t you want a zero-coupon CD? Well, there are some caveats to these CDs that you should be aware of. Keep reading to learn more about zero-coupon CDs and why one may or may not be right for you.
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How do zero-coupon CDs work?
Zero-coupon certificates are a certificate of deposit purchased at a lower price with interest accrued at the CD’s maturity date. This means that investors receive the CD at full face value upon maturity instead of making regular interest payments. While you may have to wait longer to receive compensation from a zero-coupon CD, you could end up earning more than you would with other CDs.
To help you understand how these certificates work, here’s a step-by-step rundown of how someone would obtain a zero-coupon CD.
- A person would buy a zero-coupon CD for a discounted price.
- In exchange for the discounted price, the CD does not pay interest throughout the term.
- When the maturity date comes, the person will receive the CD at full value.
Example:
Alvaro purchased a five-year zero-coupon certificate of deposit with a face value of $50,000 for only $30,000. During the CD term, Alvaro would not receive any interest payments. Once the maturity date occurs, Alvaro will receive the zero-coupon CD for $50,000.
Zero-coupon CDs vs. traditional CDs and bonds
Traditional CDs and zero-coupon CDs have a lot of similarities with each other. Additionally, many people compare zero-coupon CDs to savings bonds, and you could end up mixing up the two. Because of this, we’ll lay out the key differences between each of these.
Traditional CDs
As mentioned before, the two biggest differences between a zero-coupon CD are the interest payments and the initial purchase price.
Traditional CDs accrue interest, which the investor typically receives as monthly interest payments. Zero-coupon CDs do not accrue interest, so you won’t receive interest earnings until the CD reaches maturity.
Fortunately, you’ll likely purchase a zero-coupon CD for a lower price than a traditional CD. This is in exchange for not paying interest throughout the CD term and why the cost of a bank CD is higher.
Both of these factors could help you receive more money through a zero-coupon CD than you would through a traditional CD.
Bonds
Though both bonds and CDs are fairly low-risk investments that don’t have regular interest payments, they are two different concepts. The biggest difference between the two is when you earn interest payments.
With a bond, you will receive interest once or twice a year. With a zero-coupon CD, you will receive interest as a lump sum when the CD reaches full maturity.
Another notable difference between the two is who issues a bond and CD. Bonds are issued by a corporate or government institution while CDs are issued through banks or other financial institutions and are federally insured.
Pro Tip
If you need some extra help deciding between different CDs or different investment vehicles altogether, try reaching out to an investment advisor for help. They’ll be able to push you in the right direction for both immediate and long-term investments, including planning for your retirement.
Pros and cons of a zero-coupon CD
Now that we have an understanding of what zero-coupon CDs are, let’s review why someone may (or may not) want one. These unique CDs have definite advantages, but they also have some significant downfalls.
Pro Tip
Buying CDs isn’t the only way you can earn interest income. Interest income can be earned by depositing money into saving programs, investing in bonds, or lending money. But you should know that, no matter how it’s earned, interest income is always taxable.
Is a zero-coupon CD right for you?
A zero-coupon CD is generally great for those who can afford to invest a large amount of money and are looking for a long-term, low-risk investment. Here are some more questions you should ask yourself to help determine if this CD is right for you:
- Can I wait until the end of the term to receive compensation? While you may have a large payout coming in the end, that maturity date may not come for years. So, are you okay with waiting years until you receive any form of money from this investment?
- Am I okay with paying the taxes on my earnings? Remember, you’ll have to pay taxes on what you earn from your zero-coupon CD. So while the payout may be large, the amount of taxes you pay could also be large. Be sure you’re okay with this reality before making the commitment.
If you’re in a place where you can afford to invest a large amount of money and not have access to it for years, then a zero-coupon CD could be worth looking into. The payoff could be worth it in the end, even with the taxes you’ll owe.
How do you get a zero-coupon CD?
CDs in general can be issued through credit unions and banks both online and in person. Talk to your bank or credit union of choice to see if they offer a zero-coupon CD. But before you commit to one, be sure to compare to ensure you’re getting the best rate.
FAQs
What is a coupon in CDs?
When talking about CDs, the term “coupon” refers to periodic interest payments. Since this CD is called “zero-coupon,” that means you make no periodic interest payments.
What is a call-protected CD?
If a CD is call-protected, it means the issuer cannot close the certificate before the maturity date. You should make sure your zero-coupon CD is call-protected so that you can get the highest possible earnings.
How often is CD interest paid?
It depends on the certificate of deposit, but interest is generally paid monthly on traditional CDs. For course, this only applies to CDs that issue interest payments.
Is commercial paper issued at a discount?
Commercial paper is another form of investment vehicle that is usually unsecured and reserved for short-term investments. Though typically only sold in denominations of $100,000, commercial paper is issued at a discount and matures at face value.
Key Takeaways
- Zero-coupon CDs do not have monthly interest payments made.
- In lieu of monthly interest payments, zero-coupon CDs give you the full face value of the CD at the maturity date.
- For example, you could pay $20,000 for a CD that’s worth $30,000. At maturity, you’ll receive the full $30,000 as payment.
- Earnings made from zero-coupon CDs are taxable and will have to be paid after the maturity date.
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Camilla has a background in journalism and business communications. She specializes in writing complex information in understandable ways. She has written on a variety of topics including money, science, personal finance, politics, and more. Her work has been published in the HuffPost, KSL.com, Deseret News, and more.
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