Investors with longer time horizons and diversified savings portfolios may enjoy the convenience of zero coupon certificates of deposit. Find out why some investors prefer zero coupon CDs over other similar investments.
What is a zero coupon CD?
"Zero coupon" refers to the fact that interest accruing on this kind of CD is rolled back into the investment. Although this kind of dividend reinvestment requires additional tax planning, zero coupon CD holders enjoy some of the highest yields offered by traditional banks.
How to collect interest on zero coupon CDs
When banks offer a zero coupon CD, they withhold interest on that account until the certificate's maturity date. At that time, account holders collect the face value of their certificate, which includes the projected amount of interest earned during the term.
By collecting all of the interest at maturity, account holders qualify for significantly higher interest rates than traditional certificates of deposit. In return for such high rates and yields, depositors typically agree to hang on to zero coupon CDs for much longer terms than traditional certificates of deposit.
How to value zero coupon CDs
Current CD rates help determine the "face value" of a zero coupon CD. For instance, if rates hover at about 4%, a private bank may offer you a zero coupon CD for $50,000 with a face value of $75,000 and a term of seven years.
How to plan investments with zero coupon CDs
Zero coupon CDs require a higher degree of commitment and planning on the part of investors when compared to traditional certificates of deposit.
Taxes on CDs
In most cases, the interest earned on a zero coupon CD is taxable each year over the course of the account's term. This means that account holders must keep a separate cash reserve to cover the anticipated taxes on interest that they won't be able to withdraw for years. However, this arrangement could create some tax benefits and breaks, especially for account holders who want to avoid logging a large lump sum of interest income at the end of the term.
Why banks like talking about this best kept secret
Current CD rates often reflect the short-term needs of banks to increase their deposit bases. With larger deposit bases and reduced need to pay out on withdrawals, banks can leverage account holders' money into more lucrative investments. As a result, highly competitive banks are eager to offer zero coupon CDs to their favorite customers.
Current CD comparative rates for zero coupon CDs can be hard to come by. With relatively few customers even asking about these unusual savings instruments, banks rarely even have printed information on their offerings to hand out to customers. Therefore, investors seeking out zero coupon CDs can look for bank rates and discuss prospective deals with bank officers.