What Is a Zero-Coupon CD?

A zero-coupon CD is a certificate of deposit (CD) you purchase at a discount and that doesn’t pay out periodic interest. You’ll obtain the full value of the CD via interest earned once the CD reaches its maturity date.

However, even though you won’t receive regular interest payments, zero-coupon CDs usually come with a higher rate of return. That makes them good options for investors who don’t need immediate access to the funds.

Definition and Example of a Zero-Coupon CD

A zero-coupon CD is a certificate of deposit that does not make periodic interest payments (“coupons”) but generates a return by selling for lower than the face value that’s paid out at maturity. In the meantime, interest pushes the CD’s purchase price up to the face value (this is known as “accreted interest”).

For example, you go to your broker’s app or website and search for zero-coupon CDs. You purchase one that’s selling for $3,500 and pays $4,000 upon maturity.

How a Zero-Coupon CD Works

When you open a CD, your bank or financial institution may give you the option to take out the interest on a semi-annual basis. But when you open a zero-coupon CD, there’s no option for interest payments.

Instead, you purchase the CD at a lower amount than its face value and receive the face value once it reaches maturity. Zero-coupon CDs are usually purchased through brokerage firms such as Vanguard.

For instance, let’s say you purchase a five-year $4,000 CD at a reduced rate of $3,500. You won’t be eligible to receive interest payments throughout the five-year term, but interest will accrue to grow the CD’s value to $4,000. Once the CD reaches full maturity, you’ll receive the CD’s face value of $4,000.

Zero-coupon CDs usually have a term (time to maturity) that may be longer than what a bank would offer. Consequently, make sure you don’t need to access the money you put into a zero-coupon CD. On the flip side, purchasing a longer-term CD likely means the difference between the buy price and face value will be bigger than what you’d earn with a traditional CD’s annual percentage yield.

Although you don’t get periodic interest payments, you’ll still pay taxes on any interest earned while you wait for maturity.

Do Zero-Coupon CDs Have an Early Withdrawal Penalty?

The short answer is no. Because you’re likely to buy a zero-coupon CD through a brokerage, you’ll have the ability to sell your CD on the secondary market if you need the money. While avoiding penalties is a good thing, you may have to pay fees to your broker to execute the deal, and there’s no guarantee you can sell the CD for more than what you bought it for.

Pros and Cons of a Zero-Coupon CD

Pros Explained

• Low risk: If you take out a zero-coupon CD from a bank or credit union, it is likely FDIC-insured for up to $250,000. This guarantee against loss makes it much safer than stocks, for example.
• Higher rate of return: Zero-coupon CDs are sold at a reduced rate, and when the CD reaches maturity, you’ll receive the full value of the CD including interest. That means you’ll earn a higher rate of return than you would with a regular CD.
• Long-term savings: If you don’t need immediate access to the funds, a zero-coupon CD can be a good long-term savings strategy.

Cons Explained

• No interest payments: With a zero-coupon CD, you won’t receive any regular interest payments. Instead, you’ll receive the face value of the CD upon maturity.
• Pay taxes on the interest: Even though you won’t receive any interest until the end of the CD term, you’ll be taxed annually for the interest that accrues.
• Liquidity depends on finding a buyer: Because zero-coupon CDs are typically purchased through a broker, you’ll need to find a buyer if you want to sell the CD to get your money back. Since it’s hard to predict when your CD will sell, you may wait longer than you’d like to get your original investment back.