Q: I own a house in the District which I have rented for a number of years. I now want to sell this property, and am prepared to assist my purchaser by taking back a sizeable second trust. However, I have heard that the D.C. usury laws prohibit balloon payments, and I want your advice before completing this transaction.
A: The balloon payment has had a very tortured, twisted history in the District in recent years. A balloon payment is a transaction where the monthly payments are low, (usually based on an amortization of 20 to 30 years), but the entire balance becomes due -- in other words, balloons up -- within a shorter period of time, usually three to five years.
For example, to amortize a $25,000 note at 12 percent over three years would require monthly payments of $830.36. Obviously, this is quite steep for anyone's budget. Thus, the typical balloon would amortize this same $25,000 note over a 30-year period, thereby reducing the monthly payment to $257.16. However, at the end of a three- or five-year period, the entire balance would become due and payable.
This is known as a balloon note. The borrower usually relies on inflation to escalate the value of the property, so that when the balloon is due, the borrower can refinance -- he hopes at a lower interest rate -- and pay off the entire obligation.
Unfortunately, during the 1960s balloon notes created serious problems for many unsuspecting homeowner. Shady and fradulent home improvement contractors touting aluminum siding or driveway repairs had homeowners sign promissory notes calling for extremely low monthly payments, but at the end of one or two years, these entire notes ballooned.
Unsuspecting homeowners, unaware that balloon notes were secured with second deeds of trust on their properties, were foreclosed because they were unable to meet these balloon payments.
To protect against this problem, the D.C. City Council several years ago prohibited second-trust balloon notes if the simple interest rate exceeded 8 percent a year.
Last year, with mortgage rates galloping upward, the council drastically revised the usury laws. First trusts were permitted to go as high as 15 percent. And the council specifically addressed the balloon-note problem.
The law currently permits such a note if the secondary financing is being provided by the owner-occupant seller or a federally regulated financial institution.
However, in your example, since you apparently are not an owner-occupant seller, the balloon note is still prohibited.
There are a number of exceptions to this usury protection. Specifically, if your borrower is a not-for-profit corporation, or if the purpose of the loan is to acquire or carry on a business, professional or commercial activity, or if your borrower intends to use the property for an investment, the usury provisions of the District law do not apply and the balloon is permissible.
It is strongly recommended that you review the language of your seller's take-back note with your attorney before the final documents are signed.