What Is a Zero-Coupon Certificate of Deposit (CD)?
Let me explain what a zero-coupon certificate of deposit (CD) is—it's a type of CD that doesn't pay interest during its term. Instead, you buy it at a discount to its face value, and at maturity, you get the full amount, giving you a return on your investment without any payments along the way.
Compare this to traditional CDs, which pay interest periodically, often annually. Both types appeal to risk-averse investors because they guarantee your principal. But if you're not worried about cash flow during the term, a zero-coupon CD might suit you better.
Key Takeaways
- A zero-coupon CD skips interest payments throughout its term.
- You get compensated by receiving a face value at maturity that's higher than what you paid.
- These CDs typically offer higher returns than traditional ones to make up for no interest income.
How Zero-Coupon CDs Work
You purchase a zero-coupon CD at a significant discount, but it pays out the full face value when it matures. For example, a $100 face value CD might cost you $90, so you profit $10 at the end. The name comes from having no 'coupons' or annual interest payments.
These are low-risk investments—if you don't withdraw early, you're guaranteed a set return over the term. Since banks issue them, they're often FDIC-insured if the bank is covered.
The big plus is they usually give slightly higher returns than regular CDs. But watch out: you owe taxes on the accrued interest each year, even if you don't get the money until maturity, so plan for that. They might also be callable, meaning the bank could redeem them early and reissue at a lower rate. And obviously, no annual payments mean they're not great if you need steady cash flow.
Real World Example of a Zero-Coupon CD
Take a 5-year zero-coupon CD with a $5,000 face value sold for $4,000. You pay $4,000 upfront, and after 5 years, you receive $5,000—no interest in between.
That $1,000 profit equals about $200 accrued income per year, like a 5% annual rate, but you only get it at the end. Remember, you'll pay taxes on that accrued interest yearly, so have funds ready.
You might find this appealing if other fixed-income options yield less than 5% and you don't need cash during those 5 years.
Other articles for you
Lagging indicators are measurable factors that change after correlated economic, financial, or business variables have shifted, confirming trends rather than predicting them.
A deed is a legal document that transfers ownership of assets like property, with various types offering different protections and requirements.
Commodities are interchangeable raw materials used as inputs in production and traded on exchanges for hedging or speculation.
Negative carry is when the cost of holding an investment exceeds the income it generates.
Unlimited liability means business owners fully bear all company debts, risking their personal assets.
An underwriting group is a temporary alliance of investment bankers and broker-dealers that buys new securities from an issuer and resells them to investors for profit, sharing risks and aiding distribution.
A golden share grants its holder special veto powers over company changes to maintain control, often used by governments in privatized entities.
Extraordinary items were unusual and infrequent gains or losses separately reported on financial statements until FASB eliminated the concept in 2015 to simplify accounting.
A hub and spoke structure pools assets from multiple feeder funds into a central master fund to cut costs and improve efficiency in investments.
Clearing is the essential process in finance where trades are reconciled, funds and securities are transferred, and transactions are settled securely.