Zero-Coupon Mortgage

Definition Zero-Coupon Mortgage

By definition, a Zero-coupon mortgage is known as the long-term mortgage of the commercial kind, which defers payments of interest and principal till the time of the maturity of the said mortgage. The loan when structured in the form of an accrual note, the due interest turns into the outstanding borrowed amount. At the time of maturity, the borrower will either pay off the loan amount or take out another one, based on the prevailing rates of interest.

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How does a Zero-coupon mortgage work?

Similar to Zero Coupon bonds in nature, in Zero-coupon, the value of the annual rate of interest on the loan remains zero till the time of expiration, which is when the entire amount is to be paid alongside interest.  

Commercial projects make use of zero-coupon mortgages in cases where the required cash flow for the debt is not available till towards the end of the project. For instance, in the example of a stadium; it is because till the time the entire structure is completed and the place is actually able to host events, there isn’t going to be any revenue generation.

This case tends to involve higher credit risk. This is because the amount, including the principal and the interest, shall not usually be repaid to the lender at the maturity of the loan. This type of financing is hence usually available to only top commercial-based borrowers who have a clean credit history. A higher rate of interest is usually charged on the zero-coupon mortgages, to make up for the fact that it shall be returned in a longer duration.

With the help of a zero-coupon mortgage, the borrower can finance a large commercial project using a smaller cash flow, on the expected appreciation related to the property, the value over the loan duration is sufficient in order to pay it off.

Explaining zero-coupon mortgage with an example

For instance, if a given company takes out a zero-coupon mortgage of amount $50,000 which is due to be paid in 20 years, for the entire course of two decades, there shall be no payment made in this regard. Contrary to regular loans, the company shall not have to immediately start returning the principle and the interest in lieu of the loan.

At the end of 20 years, the company will have to return the amount of $50,000 at once, along with the compound interest on the loan or else take a new loan (refinance) according to the new rates of interest that prevail. In case the borrower fails to return the money at this time, it may lead to losing the property as well as handing over the same to the lender. Hence two additional risks of losing the property are something that the borrower has to undertake when getting into a zero-coupon mortgage.

Understanding refinance

Usually known as refinance, this is the process of replacing the terms of an ongoing credit agreement with new ones. It mostly has to do with a mortgage or a loan. Businesses decide to take refinancing in order to make favourable changes in the payment schedules rate of interests and other terms and conditions related to their contract. If and when approved, this new contract will replace the existing one and bring its new terms and conditions to play.

Refinancing is usually done when there is a constant change in the interest rate environment, which may prove to be beneficial in terms of making debt payment savings on drawing a new agreement.

What are the special situations in zero-coupon mortgages?

Here are some special cases to consider in case of zero-coupon mortgages. The investor has a huge possibility of making big money from zero-coupon bonds and mortgages. Popular among certain types of investors, mainly because of their availability in select real estate markets as well as because the zero-coupon bonds usually spell at discounted prices from the actual face value of the note.

This means that while the investors will not receive interest payments on a regular basis, the interest will keep adding to the principal amount and shall be returned to the creditors at the time of maturity. Added semi-annually, the compound interest rises along with the primary value, which creates higher returns for the investor at the end.

Zero-coupon mortgages in terms of prices can be volatile because there is no payment of coupons and the money is delivered right in the end. It is further to be noted that they are subject to the payment of income tax annually, despite the income being attributed and not being received on a regular basis by the investors. The only exception to this situation would be if the agreement of investment is not inclusive of payment promise to the investors of a certain amount, which would mean that there is no taxable yearly income to be paid currently.

In a similar investment type which is usually operated for IRA or individual retirement accounts, are other examples in which the current year taxation is not taken into account.