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Zero-coupon certificates of deposit (CDs) might be worthwhile if you're looking for a low-risk, long-term investment. Returns can be potentially higher when compared to traditional CDs, but you won't be able to access your funds during the CD's term. That may be a nonissue for investors who don't mind parting with their money for a period of time, but it's something to consider before getting a zero-coupon CD.
Here are some important things to consider when deciding if this investment is right for you.
What Are Zero-Coupon CDs?
Zero-coupon CDs work similarly to normal CDs, except they are purchased for less than the face value on the account. Once purchased, your money is then locked into the CD for the length of the maturity period. That typically ranges anywhere from one month to five years. When your account matures, you'll receive the full face value of the CD. For example, say you purchase a $5,000 CD for $3,750 with a term length of three years. That works out to a 25% discount. When the CD matures, you'll receive $5,000—a $1,250 return.
With a traditional CD, you make an initial deposit, and your money is locked into the CD for the duration of the term. A key difference from zero-coupon CDs is that interest accrues as you go with a traditional CD. When the maturity period ends, you'll get back your initial investment, plus interest. You can also withdraw funds from a traditional CD before it matures, though early withdrawal penalties usually apply.
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How to Invest in Zero-Coupon CDs
If this type of CD sounds like a good fit, you can purchase one through a bank or brokerage firm. Comparing interest rates, terms and fees can help you find a zero-coupon CD that's best for you. Also be sure you can reasonably afford the initial investment. Once your money is in a zero-coupon CD, the only way to access your funds before the maturity date is to sell it on the secondary market. There's no guarantee you'll find a buyer, however, and you could lose money on the sale. When you're ready to get a zero-coupon CD, the next step is completing an application and making the purchase. No further maintenance is required.
Pros and Cons of Zero-Coupon CDs
Pros
- There's the potential for high returns: Traditional CDs currently have rates above 5%, which is competitive, but it's possible to realize more gains with a zero-coupon CD.
- Risk is low: Returns are guaranteed. CDs offered by banks are also insured for up to $250,000. Brokerage firms provide comparable insurance coverage.
- Zero-coupon CDs are easy to open and manage: After opening a zero-coupon CD, there isn't anything you need to do. The money simply stays in the account until the maturity date. At that point, you'll receive your initial investment, along with interest. You can then reinvest the money or spend it as you please.
Cons
- Some zero-coupon CDs are callable: A zero-coupon CD could be called back by the bank or brokerage firm before it matures, then reissued at a lower rate. Callable CDs typically offer higher yields, but you could miss out on potential earnings in the future.
- Taxes are due along the way: Zero-coupon CDs don't pay out interest until the end of the term, but you're responsible for paying taxes on interest that accrues before then.
- You cannot withdraw funds before the maturity date: If you end up needing money in a zero-coupon CD before the term ends, your only option is to find a buyer on the secondary market and hope for a good price.
Alternatives to Zero-Coupon CDs
- Traditional CDs: This may be a good option for investors who want more simplicity. CD laddering can help free up liquidity. It involves purchasing multiple CDs with varying maturity dates. When done right, it can free up cash on a rolling basis.
- Bump-up or step-up CDs: With these types of CDs, the yield can increase if interest rates go up. However, they often start with a lower yield when compared to fixed-rate CDs.
- IRA CDs: Individual retirement accounts (IRAs) come with attractive tax benefits. An IRA CD is specifically invested for retirement. It's another potential way to grow your nest egg.
- High-yield savings accounts: If liquidity is important to you, a high-yield savings account might make sense. You'll have easy access to your money, though yields tend to be higher with zero-coupon CDs.
- Money market accounts: This type of account earns interest like a savings account but is also attached to a debit card or checkbook. Yields are often higher with CDs, but money market accounts make it easy to tap your funds as needed.
The Bottom Line
Zero-coupon CDs are considered low-risk investments that provide reliable returns. You'll know what you're getting from the outset—and gains tend to outpace traditional CDs. Whether it's worth it will depend largely on your investment goals and whether you anticipate needing access to your money before the account matures.
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