What Is a Zero-Coupon Mortgage?
A zero-coupon mortgage is a long-term commercial mortgage that defers all payments of principal and interest until the maturity of the mortgage. The loan's structuring is as an accrual note, meaning interest due rolls into the outstanding amount borrowed. At maturity, the borrower either pays off the note or floats another loan at the current interest rates.
- Zero-coupon mortgages are long-term commercial mortgages that defer all payments of principal and interest until maturity.
- Interest due rolls into the outstanding amount borrowed, which must be paid off at the expiry date or refinanced at prevailing interest rates.
- Commercial projects may use zero-coupon mortgages when the cash flows needed to repay the debt aren't available until the project nears completion.
- Lenders usually only offer zero-coupon mortgages to established commercial borrowers that have clean credit records.
How a Zero-Coupon Mortgage Works
Zero-coupon mortgages resemble zero-coupon bonds. The coupon, the annual interest rate paid on the loan, is zero until the expiration date when it must all be paid back in one hit, together with the full amount borrowed.
Commercial projects use zero-coupon mortgages when cash flows to service the debt are unlikely to be available until the project nears completion. An example of this would be a sports stadium. In this case, no revenues are generated until the structure is complete and able to host events.
Because total interest plus principal repayment is only received by the lender when the loan matures, the credit risk is significantly higher than with a conventional loan. As a result, lenders generally only offer this form of financing to established commercial borrowers with clean credit records. They also tend to charge a higher interest rate on zero-coupon mortgages to compensate for the lack of immediate return.
With a zero-coupon mortgage, a borrower can finance a commercial project with smaller cash flow, on the expectation that appreciation of the property value over the life of the loan is sufficient to pay it off.
Example of a Zero-Coupon Mortgage
Let's say ABC Corp. takes out a $400,000 zero-coupon mortgage due for repayment 20 years from now. Over the course of the next two decades, ABC returns nothing to the lender. Unlike conventional mortgages, the company isn’t required to immediately start gradually paying back the principal, as well as interest for the privilege of taking out a loan.
That all changes when its 20 years are up. Suddenly ABC must return the $400,000 it borrowed all at once, together with the compounded interest on the loan, or refinance at prevailing interest rates. Failure to do so will lead it to lose the property and force it to hand over the keys to the lender.
The year Kansas-based Franklin Savings Association sold the first issue of zero-coupon bonds backed by mortgages.
Investing in Zero-Coupon Mortgage Notes
Investors have the opportunity to get in on the action and make money from zero-coupon mortgages and bonds. These investments are popular among certain investors, partly due to their availability in specific real estate markets and also because zero-coupon bonds sell at a discount from the face value of the note.
Investors will not receive regular interest payments. However, the borrower will add the interest amount to the principal amount, which gets returned to the creditors at maturity. Interest will compound semiannually, and as the primary value rises, it will create higher interest payments, which roll back into the total principal sum.
Because they pay no coupons and only deliver money at maturity, zero-coupon mortgage prices can be very volatile. They are also subject to annual income tax payments, even though the income is attributed and not regularly received by investors. An exception would be if the investment agreement makes no promise to pay investors a specific return, in which case there would be no current taxable yearly income.
Another similar type of investment is operated primarily for Individual Retirement Accounts (IRAs) and other entities where current-year taxation is not a consideration.