Q: My husband and I are interested in purchasing a house, and the developer has offered us what he calls a "zero-based mortgage."
This is intriguing to us, but we really don't understand all of the ramifications of this kind of financing. Can you give us some guidance?
A: I would be very careful of entering into a zero-based mortgage. Here is how it works.
Let us assume that the purchase price is $119,000. Generally speaking, the developer/seller wants a sizeable amount of money as a "down payment," and the balance of the sales proceeds are paid off--usually within seven years--in equal monthly installments. The monthly installments are often equal to what you would pay if you were to obtain conventional financing, and of course since there is no interest added to these monthly payments, the full purchase price is paid off in a relatively short period of time.
Let's look at the numbers a little closer: Sales Price $119,000 Down Payment (approx. one-third) $40,000 Balance owed $79,000 Monthly payment $940.50
The monthly payment is calculated by dividing the balance owed ($79,000) by seven years, and then dividing that amount by 12 equal monthly payments.
Clearly, under this arrangement, you are able to pay off your house in full within a seven-year period. This sounds rather attractive, at first blush.
But let's look at the consequences of this "zero-based" mortgage. First, you are required to put down a sizeable amount of money, in this case $40,000. This is a lot of money to put down in a house purchase.
If you were to obtain a conventional mortgage, it is possible that you would only have to put down 5 percent or 10 percent of the price. If you were able to get a 10-percent-down mortgage, you would need only $11,500 and would be able to keep the $28,100 difference. This money you could keep either in a money market fund, or at least have cash available for furniture, vacations, and the like.
The second major problem with zero-based mortgages is whether the developer, by offering this kind of financing, has actually increased the sales price to accomplish the transaction. Many developers have raised their prices, and thus you may end up paying much more for the house under this type of transaction than if you were to obtain conventional financing. More importantly, in today's marketplace, it is possible that if you obtain conventional financing, you might be able to get a better deal from the seller on the price. In other words, under a zero-based mortgage the developer is not getting the cash up front, whereas they would be getting most--if not all--of the cash if you obtained financing elsewhere. Money talks, and you may be able to negotiate a discounted price below the $119,000.
Third, and perhaps most significantly, there is a serious question as to whether you can get any tax deductions under this kind of transaction. The Internal Revenue Service has suggested informally that home buyers under the zero-based mortgage will be able to deduct 10 percent interest payments each year--even though they are not actually paying interest. This is based on the "imputed interest" theory, which says that since the developer may be charged imputed interest on the loan, you as a home buyer can deduct the same amount of the interest.
If this tax deduction does in fact become available, then it may shed a different light on the zero-based mortgage concept. However, the Internal Revenue Service has thus far been unwilling to give a definitive ruling, so the home buyer enters into this kind of transaction at his or her own risk.
You should "do the numbers." Even if the interest deduction is available to you, it might be better to put less money down into the property, negotiate a better sales price, and deduct the interest payments yearly on the conventional mortgage. Keep in mind that not all of us keep our house for 30 years. Thus, when you sell your house five to 10 years later, you will not have to pay all of the high interest costs projected over the full life of the loan.
This is not to say that the zero-based mortgage is not an interesting concept. For some people it may make sense. For example, some people who work for international agencies--such as the World Bank--are not eligible to deduct mortgage interest payments. Under this kind of arrangement, the zero-based mortgage may be an ideal solution for your individual needs. Additionally, if you are on the edge of retirement, and anticipate that your monthly income will be significantly reduced, the future tax advantage of deducting the mortgage interest payments may not be so significant, and again the zero-based mortgage may be your cup of tea.
Don't be misled by the statements offered by developers that the zero-based mortgage offers you a guaranteed tax deduction. This issue has not yet been resolved.
Benny L. Kass is a Washington attorney. Write him in care of the real estate section, The Washington Post, 1150 15th St. NW, Washington 20071.