When self-amortizing, long-term loans became popular in the 1930's, they largely replaced the "term" mortgage. A term mortgage was a short loan, say five years, which required only payments for interest. At the end of the term, the borrower repaid the entire principal.
Because borrowers normally did not have the entire value of the mortgage in cash at any one time, at the end of each term they would go out and get new financing. This process meant that loan balances were forever outstanding and that new fees and interest rates could be charged every few years.
Today the term loan, with minor modifications, is back, only now it is called a "rollover" or "Canadian rollover" mortgage. (Rollovers are used more widely in Canada than the U.S.) With a rollover loan, a borrower gets a mortgage for a stipulated amount and with payments figured on a 25- or 30-year term. The loan, however, only lasts five years.
At the end of five years, there is a gargantuan balloon payment to consider. Because of the way that 25- and 30-year loans are amortized, the size of the balloon payment will not be very much smaller than the original principal balance. For example, at the end of five years, a fixed-rate $75,000 loan at 13 percent interest would have a remaining mortgage balance of $73,561.21.
What does a buyer do now? In many cases, rollover loans have a provision through which the lender guarantees to provide another five-year note. However, unless there is a cap, the interest rate in the second term can be any number selected by the lender.
The lender is in a good position to get a premium rate because the borrower's alternative, other than selling or being foreclosed, is to refinance with someone else. Refinancing is likely to involve costly loan origination fees, points, and settlement charges -- new title searches, appraisals, etc. A premium interest rate in such circumstances may be the best of several very difficult choices.
Even if a second five-year term is guaranteed, a third term is usually not. At this point, a borrower must find new financing if the property is to be retained.
The lack of a long-term commitment raises all the problems associated with balloon financing generally: There is no guarantee that funds will be available to refinance the rollover note, and there is no promise that, if such funds are available, the borrower will qualify for financing. Even if money is available, interests rates may be so high that new financing is ludicrously expensive anyway.
It is difficult to imagine a situation where rollover financing is advantageous to borrowers. If interest rates are abnormally high, the time when rollover loans are most likely to be in style, one would be better off with an adjustable-rate mortgage. The ARM interest rate is likely to be at or below current market levels and, when rates drop, so will ARM costs. Moreover, an ARM is a long-term commitment by a lender. Although borrowers may worry about rising monthly payments with an ARM, at least they are not faced with the certainty of a giant balloon payment.
If interest rates are low, the need for a rollover loan approaches zero. Why get term financing when plenty of money is available in other loan formats?
Questions to ask:
* What is the interest rate for conventional financing?
* What is the interest rate for a rollover loan?
* What is the term of the rollover loan?
* Does the lender guarantee to continue the loan for an additional term?
* Must you be "financially qualified" to continue rollover financing for a second term?
* Will the lender continue the loan for a third term? A fourth?
* Will the lender allow you to convert to conventional financing if interest rates decline to a certain point? What point?
* If the lender does guarantee to renew the loan, how much notice will you receive regarding any new interest rate?
* If there a cap on the interest level for a second term?
* Is the rollover loan assumable?
* Can the rollover loan be prepaid in whole or in part without penalty at any time?
NEXT WEEK: Wrap-around financing