A balloon payment is a single payment due at the end of a partially amortized loan.
Let’s say you are considering a seller carryback sale with a $100,000 note at 8% amortized over 360 months. The monthly payment is $733.76. You don’t like the idea of waiting 30 years to get your money. Your buyer thinks he will be in a position to refinance a few years down the road, so you would then be able to get your money earlier rather than later.
If you and your buyer agreed to the same terms, but you would get a balloon payment in 7 years, your buyer would still pay you $733.76 monthly, and then have a single payment to you in month 84 of $92,477.94. At that point, you have been paid off, you are out of the note.
What is good and bad about this arrangement?
The good is obvious – as a seller, you have your cash in 7 years rather than 30 years. You don’t have to worry about your buyer making or not making his payment next month. Plus, if you have another business or investment opportunity, the balloon payment might be a great source for the cash you need.
Your buyer may benefit as well. Let’s say that interest rates 7 years from now are higher than today. How about 6%. The buyer could refinance the 7 year balance of $92,477.94 for 240 months with a monthly payment of $662.54. That’s $71.22 less than he was paying you, and for a shorter term. The fact that you demanded a higher interest rate in your promissory note actually helped your buyer in the long run.
Here is the bad. Sellers and buyers are misusing the balloon payment provision in their negotiations. I have talked to sellers who know nothing about the credit history of their buyer, but will then agree to ridiculous terms. What’s ridiculous? How about no downpayment, 3% interest only payments for 3 years, a balloon payment due after 36 months. If the seller does not know who he is dealing with, does he have a buyer or a renter? Where is the commitment from the buyer?
This example may seem exaggerated to you. It’s the truth. I have seen countless other arrangements that are not as bad as this one, but close. If the buyer cannot come up with the balloon payment when due, what is the seller going to do? He has 2 options – foreclose or extend the terms of the note. To most sellers, neither option is attractive. He could have avoided either possibilty by being more business like in the beginning, by knowing his buyer and demanding terms that were realistic and protective of him and his buyer. If the buyer would not agree, find another buyer. The housing woes we have had for several years now have caused some desperate sellers to sell their property to the first person that comes along, and then agree to terms that will get that person in the property. Potential disaster awaits.
Most notebuyers are extremely wary of notes with balloon payments, simply because experience has shown that the balloon will not be paid when due. So, the pricing for the note will ignore the balloon, and assume that it is a fully amortized note.
If you want a balloon in your transaction, a 7 year due date is a safer bet in the current climate. Coupled with a high interest rate, strong downpayment, and amortized payments, you are doing a better job of protecting yourself should you decide to keep the note or sell it.
As always, call or email me if you have questions before you sell your property.
