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.

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.

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.

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.