Whenever balloon loans are discussed, great attention generally is paid to the risk: Borrowers who fail to make the large final payment due at the end of the loan term may lose their property through a foreclosure action. Despite this, balloon payments are common because they also offer advantages.
Balloon notes generally feature lower monthly payments than self-amortizing, long-term loans with equal interest rates. Like many other mortgage formats, they also help to offset the effect of inflation: It pays to borrow money today that can be repaid tomorrow with devalued "microdollars," cash that buys less because its purchasing power has been eroded by inflation. This happens whenever the cost of money over time is less than the rate of inflation.
The balance between the risk and benefit of a balloon payment must be weighed carefully. Buyers without adequate financial means, discipline or planning should stay away from balloon financing. Those who do use it must develop a rational strategy, possibly one of the following.
Loan term. In general, borrowers should seek the longest possible term when using balloon financing. More years mean more potential opportunities to renegotiate loans, refinance property or sell real estate if necessary.
Refinance in part. If the first mortgage has a balloon payment, it may be possible to raise needed cash by obtaining a second mortgage, hopefully one without a balloon requirement.
Get a new balloon note. This at least will defer it. With the new balloon financing, at least try to get better terms; that is, a longer note if possible, lower interest or better monthly payments.
Refinance completely. If you have have a good credit record, you may be able to refinance with a self-amortizing loan from a commercial lender. But if you have both a low-interest assumed first mortgage and a second trust with a balloon payment, the first trust will be lost and the cost of refinancing must be calculated to include not only settlement charges but the additional ongoing expenses represented by higher financing costs.
Get an extension. If you have a good payment record, a lender may want to continue the loan, particularly if the rate of return is at or above current market levels. To gain the most leverage, couple an extension with an interest increase long before the balloon payment is due.
Sell part of the property. It may be possible to subdivide your property and sell off some portion to make a balloon payment.
Sell an interest in the property. Enter into an equity-sharing arrangement with a cash-rich buyer. This will eliminate the balloon payment while diluting your interest in the future profits, benefits and losses associated with property.
Sell the property. Investment buyers frequently will acquire property that is financed with a balloon note with the intention of marketing it before the balloon payment is due. The proceeds from the sale then are used to pay off all liens against the property, including the balloon note. In considering this approach, one must wonder what happens if the value of the property does not appreciate or if the cost of marketing eliminates all profit.
Questions to ask:
* How large is the balloon payment?
* What is the rate of interest?
* When is the balloon payment due?
* How long will refinancing take? Be cartain to allow extra time in case an application is delayed or rejected and additional weeks or months are needed to process a new or revised application.
* What are the tax implications of subdividing property, particularly land that is part of a personal residence? What are the tax implications of entering into a shared-equity arrangement? Speak to a tax consultant for current advice. NEXT WEEK: How to avoid bad deals
Peter G. Miller is a Washington-area real estate broker.