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 maturity.
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 current interest rates.
BREAKING DOWN Zero-Coupon Mortgage
Commercial projects use zero-coupon mortgages where cash flows to service the debt may not be available until the project nears completion. An example of this would be a sports stadium, where revenues will not be available until the structure is complete and able to host events.
As 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. Lenders generally offer this form of financing to established commercial borrowers with clean credit records. 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 off the loan.
Investing in Zero-Coupon Mortgage Notes
Many investors like zero coupon mortgages and bonds. One reason is that of their availability in specific real estate markets. Also appealing is that 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. This amount gets returned to the creditors at maturity. Interest will compound semi-annually, and as the primary value rises, it will create higher interest payments, which roll back into the total principal amount.
Income tax is due each year, even though the income is attributed and not regularly received by investors. But, if the investment agreement makes no promise to pay investors a specific return, there would be no current taxable yearly income. Another similar type of investment is operated primarily for Individual Retirement Accounts and other entities where current-year taxation is not a consideration.
Calculating Bond Interest Rates
Zero coupon mortgages and bonds do not pay interest but are traded at a deep discount, rendering profit at maturity with bond redemption for its full face value. Because of this, their pricing tends to be more volatile than coupon bond pricing. The actual, real, or effective interest rate of a bond is the rate that will discount all of the future cash receipts back to the amount of cash paid to buy the bond.
This interest rate is also known as the yield to maturity, yield, and market interest rate. Bonds will sell at either a discount or a premium to the face value. This price is the bond's market value. When the bond's declared interest rate is less than the prevailing market rate, the market value of the bond is less than the face amount at maturity for the product. The product sells at a discount.
If the bond's declared rate is more than the prevailing market rate, the bond will have a market value where it is more than the face value at maturity. In this case, the bond sells at a premium.