A balloon payment is a common addition to an owner-financed note, mortgage, trust deed or land contract. Savvy sellers, real estate professionals, and note brokers know this is by design rather than accident. Here’s why balloon payments can be good for mortgage notes:
(Editor’s Note: Please be sure to read the updated comments at the end of this article pertaining to changes in market conditions related to balloon payments since this article was initially published. Also refer to How Dodd Frank Laws Apply to Seller Financing).
Purchaser Buys Time
When a seller offers owner financing it allows the buyer to not only purchase the home but also buy some time. The buyer has the opportunity to build equity, establish a payment history, and improve their credit rating, important factors in obtaining a home mortgage loan from a lender.
While a fully amortized note allows for repayment in substantially equal payments over time, a balloon clause results in a large payment on the balloon date that will pay off the remaining balance plus interest. Including a balloon payment provides the motivation in addition to the time a buyer may need to qualify for bank refinancing. Instead of refinancing when they get around to it, the buyer has a deadline to meet in the form of the balloon date.
Provides Seller Flexibility
Sometimes it is hard to know what life will bring next year let alone in two or three decades. While accepting payments from the buyer might provide a necessary solution, waiting 20 to 30 years for payment in full can be a long time.
Even if a seller is comfortable waiting out the full amortization period at closing, time has a way of changing circumstances and needs. Including a balloon payment to shorten the term to 5, 7 or 10 years can provide flexibility and peace of mind to the seller. If the seller still desires the monthly payments and interest income they can always agree to extend the balloon payment for the buyer.
Improves Note Value
One of the best reasons to include a balloon payment when using owner financing is the increased value to investors. Should the note holder ever decide to sell the payments for cash, a note buyer can usually pay more for a balloon note than a fully amortized note. This is due to the time value of money concept making money due now worth more than money due later.
To illustrate, if a seller agreed to owner finance $200,000 at 8% interest for 30 years the buyer would make payments of $1,467.53 each for the next 360 months. If an investor were willing to purchase this note for a 9% return the seller would receive approximately $182,387.
Now look what happens if the note is written to include a balloon payment with the balance all due and payable in five years. The investor could now pay $192,138, almost $10,000 more, and still achieve a 9% yield.
The payment, interest rate, and yield rate all remained the same. The only difference was the addition of a five-year balloon payment rather than allowing the note to fully amortize in 30 years. This one change has the potential to put almost 10 grand more in the seller’s pocket should the note be sold to a mortgage note buyer!
The increased value to an investor combined with the seller’s flexibility and the purchaser’s need for time all work together to make a balloon payment good for owner financed mortgage notes. But like most good things, a little can go a long way. Unfortunately many owner financed notes combine a balloon payment with high risk factors turning a positive to a negative as detailed in Owner Financing – Avoid 5 Balloon Mortgage Pitfalls.