Owner Financing – Why Balloon Payments are Good for Mortgage Notes

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 comment at the end of this article pertaining to changes in market conditions related to balloon payments since this article was initially published).

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.

 

About Tracy Z

Tracy combines her knowledge of cash flow notes with the power of marketing online to help grow your business! She can be reached at Tracy@NoteInvestor.com 1-888-999-7905 or at Exposure One Marketing.

Comments

  1. David Cargill says:

    Almost 5 yrs ago I did an owner-financed sale with a balloon payment to an LLC. The buyer recently contacted me and said he would like to extend the balloon payment by about 6 months. I don’t really object to the extension; however, I do not know exactly how to proceed.
    Should I go back to the title company that did the original paperwork and have them finalize the new terms? Do they have the expertise to protect me with this or do I need to get an attorney (if so, what kind of attorney would that be?).
    The buyer has never been late on a payment but has at times let the taxes become delinquent. Perhaps incorporating the tax payments into the new payment amount would be a good idea.
    Any advice would be greatly appreciated.

    • Hello David!
      Great questions and you are definitely on the right track by going back to the title company or attorney to formalize the extension. I’m happy to share some thoughts based on our experiences but have to insert the fine print that I’m not an attorney so unable to provide legal advice.

      When it comes to extending the balloon I keep three things in mind:

      Get Realistic

      What is the likelihood the payer/buyer can repay? Extending a balloon when the buyer is making monthly payments can be much better than foreclosing. Most of us hold notes for the monthly cash flow and prefer not to own the actual property. Foreclosure can take quite a bit of time and expense so working with they payer/buyer can be a good option. In this situation think about if the payer can realistically pay in 6 months. If not, perhaps a longer extension might be useful to both of you so you are not having this conversation again in 6 months :) . Find out the barriers for the buyer to paying the balloon off now and see where improvements might be made to change that later (is the issue income, value, credit, etc.)

      Make It Worth Your While
      The buyer will be saving money if they don’t have to obtain new financing right now. While having the relief of not foreclosing might be enough to compensate you for the extension also give some thought to whether an increase in the interest rate, an adjustment to payments, or working in the reserves you mentioned for taxes would make it worth your while.

      Protect Yourself With Legal Documentation
      Definitely document the extension with a modification to the note and mortgage as you mentioned. Changing the terms of the note has the potential to affect your lien position and enforcability – especially if there are junior lien holders. You will want to work with the title company or a competent real estate attorney to draw up the documents. Which one you use really depends on what is more customary in your state. It might also be good to update the lender’s or mortgagee’s title insurance policy with the modification.

      Hope that helps and thanks for reading and commenting at NoteInvestor.com

      Tracy Z. Rewey

      • Lynn Martin says:

        I had thought that the Safe Act of 2008 and the Dodd Frank Act of 2010 had prevented balloon notes from owner financed mortgages. Judging from these comments I am guessing that is not true and a balloon note is allowed? Also, can the owner/mortgage holder foreclose on the property just due to the balloon note not being paid but all other provisions of the mortgage note were paid (taxes, insurance, monthly payments). And finally, can the owner/mortgage holder change the terms if the balloon is not paid to require higher payments and enforce that agreement if the mortgagee never signed the documents but actually paid the higher monthly amount due to threats by the owner’s attorney?

  2. Gregory Wilcox says:

    If you owned a property free and clear would you lease it or sale it owner financed it.

    Thanks Greg

    • Tracy Z says:

      Hello Gregory! If I had confidence in the buyer I would personally opt for seller financing because I like the long term interest income. If I thought the buyer needed to first prove their payment habits I would consider the lease option first. However it depends on your ultimate goals. This article from our archives does a good job of weighing the pros and cons of the lease option vs. seller financing: http://noteinvestor.com/sellers-corner/lease-option-or-seller-finance/

  3. Do you still feel the same way about balloons today as when this was published in 2009?

    • Hello Marc and excellent question!

      From just a time value of money point of view balloon notes are more valuable. If it was based strictly on running a yield against a payment stream then a short amount of time would make the Present Value at the desired yield greater. However, the current market conditions have left it almost impossible for note payers to get refinancing – unless they are A+ credit, stable income, and great equity (which isn’t the standard owner financing buyer :) ). So that means the chances of an investor actually receiving the balloon payment have gone way down.

      Some investors will still consider an offer but will assume the note amortizes rather than balloons when they run the yield against the cash flow. Other investors might want the balloon eliminated if they are concerned about it being made.

      Another reason some investors are nervous about balloon payments are some of the new regulations (from the HUD Safe Act and the Dodd-Frank Act) relating to disclosures and requirements for balloon notes. When creating new notes (with or without balloons) be sure to consult with an attorney.

      I know you are also in the seller financed note business. Are you experiencing similar changes in your business?

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