Balloon Loans – What You Need To Know

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“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.

The Scenario

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.

Conclusion

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 info@commanderfunding.com for more information.

 

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Equipment Leasing 101

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“Opportunities don’t happen. You create them.”

– Chris Grosser

Is your business short on cash, but in need of new equipment? Consider leasing. Leasing equipment may be a better alternative to buying, depending on your situation and the particular needs of your business.

Today, leasing is common practice in the business world. Equipment finance has increased tremendously since the 2008-09 recession, and only began to decrease in 2016 due to a variety of factors including the drop in oil prices, as well as an overall contraction in the US economy, according to the Equipment Leasing and Finance Association. 2017’s overall capital spending is expected to be better, though, due in part to solid employment numbers and a generally higher level of business confidence.

Comparing Leasing to Buying

When you purchase a vehicle or a piece of equipment, you pay for either using cash or by financing the balance. After finishing the payments for the item, you own it outright.

Equipment leasing, on the other hand, is essentially a long-term rental agreement. The lender, or rather lessor, buys and owns the equipment and then rents it to a business individual (the lessee) at a flat monthly rate for a set number of months. At the end of the lease period, the lessee has several options, which will have been agreed upon at the outset. It can either purchase the equipment for its fair market value or some other predetermined amount (this is known as a Capital Lease), continue leasing via a new agreement, or return it and lease new equipment, in what is known as an Operating Lease.
With a lease, you actually only pay for the use of the equipment. At the end of the lease period, you could end up owning nothing. So why lease? The answer is simple: By leasing equipment, you leave funds in the bank that can be used for other purposes. Since lease payments are usually smaller than regular loan payments, you retain more capital to support the business in other ways.

However, keep in mind that a lease is not cancelable like a bank loan or other debt. If you need to get out of a standard loan agreement, you can sell the equipment and pay off the loan, or even refinance the loan for more favorable terms. With a lease, you generally have no option but to pay off the lease in full.
So what kinds of equipment make the most sense for a small business to lease? According to research by the SBA, the most common items leased are office equipment, computers, and trucks and vehicles.

Benefits of Leasing

Leasing equipment offers a wide range of benefits, from consistency with expenses to increased cash flow. But perhaps the most significant advantage of leasing is the ability to maintain up-to-date equipment. An Operating Lease allows your business to easily and affordably add equipment or upgrade to completely new piece machinery to meet changing needs. This allows you as a business owner to transfer the risk of being caught with obsolete equipment to the leasing company.

Leasing is essentially an alternative to traditional financing and can be great for companies that are perhaps not able to obtain business loans. Here are some other advantages of leasing:

• 100-percent financing – In many cases, leasing requires no down payment. This allows you to ‘finance’ an entire purchase, including software, hardware, consulting, maintenance, freight, installation, and training costs.
• Ease and convenience – Applying for a lease is easy, and lease arrangements can be structured to meet your individual requirements. Equipment leases can range from $2,000 to as much as $2 million. For smaller amounts, you can complete a brief application and receive a final decision within days—often with no financial reports or tax returns needed. Lease agreements for more than $100,000 generally require detailed financial information from the business, and the leasing company conducts a more thorough credit analysis than it would for a smaller deal.
• Fixed, predictable payments – Having fixed lease payments enables you to accurately predict the impact of equipment expenses on your business cash flow.
• Conserves working capital – Leasing conserves available capital by requiring only a minimal initial outlay of cash.
• Tax advantages – Operating leases are generally treated as a 100-percent, tax-deductible business expense paid from pre-tax revenues instead of after-tax profits.
• Protection against inflation – Lease payments are based on the dollar’s current value. And unlike bank lines of credit with fluctuating rates, your payments are fixed regardless of what happens to the market tomorrow, making it easier to budget, forecast and grow your business.

If you’d like to discuss leasing opportunities in more depth, please contact us on (888) 748-7731 or info@commanderfunding.com.