Savvy Consumers Deflate Balloon Note Options
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Balloon notes can be seen as mortgages where money remains owed to the lender at the end of the loan term. For instance, suppose we have a $100,000 loan at 6.5 percent interest. Over 30 years the monthly bill for principal and interest would be $632.07
To make a balloon note we could keep the same loan amount and require that same monthly payment, but also cut the term of the loan. If the loan lasts five years, then the amount due at the end of the loan term would total a mere $93,610.81. Or, if the loan lasts seven years, then only $90,416.01 would be due.
For most people $90,000 or more is not pocket change. It’s big money and so at the end of the loan term, several things might happen.
- Uncle Wilbur dies and leaves you $90,000 and change.
- You refinance the loan at the rates and terms available in a few years.
- You live like a financial hermit, save money, eat beans, and pay the debt in full and on time.
Most of us can probably eliminate the Uncle Wilbur option, and an increase in the financial hermit population seems unlikely in a country with a minimal savings rate. This means the most likely way to avoid foreclosure is by refinancing the balloon payment.
But, alas, things don’t always work out as planned. What happens in five or seven years if rates rise but your income doesn’t and you no longer qualify for financing? Or, what happens if property values decline and lenders will not provide a loan big enough to cover the balloon payment?
At this point someone might mention that balloon financing is often available at somewhat lower rates than competing 15- or 30-year loan products. Freddie Mac points out that in a market where a typical 30-year loan is priced at 7.58 percent interest, a five-year balloon note might be available for 7.02 percent.
But interest is not the only cost faced by borrowers. There is a cost to close, and if you refinance there is likely to be a need for a new settlement, complete with title searches, surveys, tax payments, legal fees, and other expenses. While additional closings may not be “interest,” they are surely an expense which reduces checking account balances and personal wealth.
Some balloon programs allow borrowers to avoid refinancing costs, continue the loan and convert or re-set the loan’s interest rate. That may be a better deal than refinancing — if the new interest rate is competitive, if qualification standards allow for continuation, and if the lender does not have a right to unilaterally decline the loan. But why have a mortgage with so many future “ifs” when assured 30-year ARM financing is available?
For most people, balloon notes represent too much cost and too little security. The public understands such factors, the reason balloon notes represent a tiny part of the mortgage marketplace.
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Published originally by Realty Times on August 24, 1999 and posted with permission.
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