The name comes from two Quichua words: sara meaning corn, and uma meaning head. Corn head, named both for the maize that grew on the surrounding slopes and for the color of the gold mined here, which the Quechua-speaking people compared to a corncob. Why the spelling drifted from Saruma to Zaruma is unclear. The historian Jorge Núñez argues for a different etymology entirely, suggesting Zaruma actually means small mountain peak, which fits the geography just as well. The town sits at 1,200 meters above sea level on an inter-Andean route where the Vizcaya range branches off from the Chilla mountains, perched on the edge of a long ridge with the river valleys falling away on either side.

The Cañari people settled this country between 500 and 1400 CE, leaving archaeological sites at Guayquichuma, Chepel, Payama, Trencilla, and elsewhere. In the 1480s the Inca arrived under Huayna Capac and enslaved the Cañari for fifty years. When Atahualpa was captured by the Spanish in 1532, the local Inca chief Quinará gathered gold for the ransom, but on learning Atahualpa had been executed anyway, he reportedly buried the treasure in deep galleries near the Guatuchi Hacienda in what is now Loja Province. Whether the gold remains there or whether the story is myth, no one has ever found it. In 1549, the Spanish caudillo Alonso de Mercadillo founded the first Spanish settlement here. The gold was so important that Philip II granted Zaruma the title Villa Real de San Antonio del Cerro de Oro de Zaruma on October 17, 1593.

On January 20, 1749, an earthquake destroyed the city and most of its mines. To make matters worse for the Spanish, an indigenous rebellion erupted in the aftermath, and the survivors fled. Zaruma fell into deep depression. Over decades the town was slowly rebuilt, with the Crown authorizing the importation of indigenous laborers to keep gold flowing. Independence came on November 26, 1820, when local patriots, supported by intellectuals from Cuenca, declared Zaruma free of Spain despite fierce opposition from royalist Loja. The ringleaders, Fray Justo Gaona and Francisco Barnuevo among others, signed the act in the Loja council house. Independence brought another economic collapse, but the mining never quite died. In 1860, the Great Zaruma Gold Mining Company Limited was formed with British capital of £250,000.

On November 29, 1882, Zaruma joined Machala and Santa Rosa to declare a new province in honor of the gold beneath them: El Oro. Zaruma served as the capital until 1884, when administrative reorganization moved the seat to Machala. The town has been on UNESCO's tentative list for World Heritage status since 1998, and was named a Pueblo Mágico in 2019. Its republic-era wooden architecture, painted in the soft colors of El Oro coffee country, is the kind of urban fabric that does not survive in many other Latin American mining towns. In 2022, arachnologists named a large new species of tarantula after the town: Pamphobeteus zaruma, described by Sherwood and colleagues that year.

Modern Zaruma lives with a problem its colonial founders never planned for. Centuries of largely unregulated mining beneath the town, much of it illegal in recent decades, have left the bedrock under streets, schools, and homes riddled with tunnels. In December 2017 a sinkhole opened beneath a school. Other collapses have followed. The mining that built the town is, very literally, eating it from below. The town's response has been complicated by the same fact that drove the Spanish here in the first place: the gold is still here, and it still feeds families. Crypto-Jewish heritage, suggested by old customs and traces of Ladino dialect, is another quiet thread in Zaruma's identity. In December 2013, the Israeli ambassador formally visited and was given the keys to the city. The mountain stands above the town. The town stands above the holes.