“Acquaintance. A person whom we know well enough to borrow from, but not well enough to lend to.”
– Ambrose Bierce, The Unabridged Devil’s Dictionary.
In the modern financial economy, lenders provide products tailored to just about any situation. Balloon loans are one such product that can be useful in some situations, but carry a serious downside if you’re not careful. So what is a balloon loan, you may ask? The term may conjure up images of hot air, or floating happily around the world in 80 days. The reality, as you’ve no doubt already guessed, has nothing to do with these. A balloon loan is a financial vehicle with considerable power for the savvy borrower. Fail to plan carefully, however, and your financial world could certainly burst.
What is a Balloon Loan?
A balloon loan is fixed-rate mortgage for a set, usually short, period of time. Unlike a traditional fixed rate long-term loan, the interest rate on a balloon loan is often nearly as low as that of an adjustable rate mortgage, because the loan does not fully amortize over the loan period. As a result, there is a potential hazard waiting for the unsophisticated borrower at the end of the term.
Rather than a fifteen or thirty year repayment term, a balloon loan will typically last five to ten years. Because the loan does not amortize by the end of that time (known at the ‘Maturity Date’), there remains a sizable principal balance at the end of the term, which the borrower must then pay in full to avoid default. Yes, that’s right. In full. Let’s take a careful look at how this can play out.
Now imagine that sometime in 2018, you find a property you love but can’t afford the payments on a standard commercial mortgage. Your financial advisor identifies a lender willing to write you a balloon loan that has a much lower, very affordable monthly payment. The loan is for $400,000 and has a 7 year repayment term, with a 30-year amortization period. By the end of the seventh year, you’ve diligently kept up with your payments and managed to pay the loan down by, say, $50,000, so at this point you still owe the lender $350,000. Here’s the kicker: you must now come up with the remaining $350,000 to pay off the loan, on pain of foreclosure. Some would consider this to be unnecessarily risky, and only suitable for borrowers who expect to come into a greatly increased revenue stream before the end of the loan period, which they can then use to service the remaining debt.
In practice, the majority of borrowers who opt for a balloon loan fully intend to refinance the property (or else sell it) at some point before the end of the loan period. While this may be a sound plan in principle, keep in mind that your ability to refinance is no foregone conclusion. The terms of a potential refinance will of course depend heavily on the prevailing interest rates when the time comes. Another source of uncertainty is the future health and creditworthiness of your business, upon which the terms of any future loan will also depend. Further, the value of the property may have fallen by the time the original loan matures, which could lead to a shortfall if you decide to sell in order to finance that balloon payment. As you can see, there are plenty of hazards to consider before opting for this unusual kind of loan.
To a degree, balloon loans are about seeing the future. You, as the borrower, are looking into the tea leaves and betting on future interest rates and other hard-to-predict factors to do with your business. While a balloon loan definitely has its pluses and can be a useful way to reduce current mortgage payments, be sure to weigh up the risk-reward proposition and the likely outcomes before signing on the dotted line. As long as you understand the risks and build in appropriate safety factors to your financial plan, you and your business can benefit greatly from the advantages a balloon loan has to offer. If, on the other hand, you find the prospect of a balloon loan too risky, you should look into a loan with an initial fixed term, say five years, followed by a term with a floating-rate, for example prime + 0.5%. Another alternative is an SBA loan, for example, which will typically require the term of the loan to match its amortization period.
To learn more about balloon loans, SBA loans, and any other kind of financing that may be right for your business, contact us on (888) 748-7731 or email@example.com for more information.