Sometimes I will get pitched properties with seller financing that have a balloon mortgage. The balloons for these deals typically come due around 5-10 years from the time of the sale. For those of you are are new to investing, a balloon means that the entire balance of the mortgage will need to be paid by the deadline that is set when you buy the property, or else the holder of the note can foreclose.
When I express concern about the balloon, the response I typically get is, “Don’t worry about that, you can refinance out in a couple of years.” Those statements are made in such a matter-of-fact-tone, that the person, who is typically an agent, appears to see my refinance as a foregone conclusion. Well, of course this statement is said in a matter-of-fact-tone as it is typically said by an agent who will not be anywhere near this deal in 5 years, so it is no sweat for him/her.
Keep in mind, these properties are typically pitched with a top dollar price. The idea seems to be that because seller financing is being offered the property is automatically a good deal regardless of how bad the price/terms are. However, seller financing is not automatically a good deal as will be explained.
First, let’s go back to a time early in my investing career where my thoughts on balloons were originally cultivated. When I first learned about balloons, I started to discuss them with people who were much wiser and experienced than I. What I learned from these seasoned investors about balloons can be summed up in a simple quote from my mentor, Clyde Wilson, “Balloons are for the circus.” This statement roughly translated means: don't get balloon mortgages.
- An Investor Should Always Look to Minimize Risk Where Possible
When I buy real estate, I want to do so in a manner that minimizes risk. To minimize risk, I have to purchase in a way that minimizes my exposure to things out of my control, including market fluctuation. I can minimize market fluctuation by purchasing at either a great price or great terms. However, if I buy a property at top price with a balloon mortgage (bad price & bad terms), then I am putting myself at the mercy of market fluctuations, which would lead to a lot of sleepless nights and Pepto-Bismol, both of which I do my best to avoid.
To see what I mean with regards to market fluctuations, let me give you an example of buying in a manner where market fluctuation is minimized. Imagine our friend Kurtz buying a single family home for $100,000, with $10,000 down and a $90,000 mortgage. The property has monthly rents of $1,000 and an expense ratio of 40% (meaning $400/month is going towards/being allotted for taxes, insurance, repairs, etc). Further imagine that the $90,000 mortgage has an interest rate of 4%, and is fixed for 30 years and fully amortized with monthly payments of $429.67.
To summarize this deal:
- Price: $100,000
- Mortgage: $90,000
- Rent: $1,000/month
- Expenses: $500/month
- Mortgage terms: 4%, 30 year fixed, fully amortized, payments $429.67/month
- Net cash flow after mortgage and expenses: $1,000 - $400 - $429.67 = $170.33/month
So, Kurtz collects $1,000 in rent, pays/allots $400 to expenses, pays $429.67 to the mortgage, leaving him $170.33/month. This deal, despite popular belief, is not very susceptible to market fluctuation. If the real estate market crashed tomorrow, and the price of the property went to half of what it was, so what? The property is still paying for itself so life will continue as always. Granted, Kurtz’s net worth will go down, but not his cash flow. Kurtz simply allows the tenant to keep paying the mortgage until it is paid in full. Yes, there is a risk that market rents could drop, which has happened, but such drops are rare and the drops are typically not nearly as dramatic as drops in price. So, Kurtz with this deal has 3 "exits": 1. Sell 2. Refinance 3. Keep renting out and paying down the mortgage ("pay & wait").
2. Balloon Mortgages Add Risk
The safeness that comes with the above-described deal is completely lost when there is a balloon in place. For example, if Kurtz did the same deal above with the same rents and expenses, but the mortgage was a 4% amortized for 30 years, but due in 5 (meaning that the monthly payments are calculated as if the loan lasts for 30 years, but the balance will be due in 5 years from the sale), Kurtz now is extremely aware/concerned of the market price. Now, we need to figure out what the balloon due in five years would be, and to do that we turn to our trusted financial calculator.
Answer: (Enter the following digits into your calculator. If you don’t have one, no worries, simply follow along)
- N (Number of months) = 60 (we are computing how much will be owed on the 30 year mortgage above in 5 years)
- I/YR (interest rate/year) = 4 (the interest rate on the mortgage is 4%)
- PV (present value) = 90,000 (the original balance of the loan)
- PMT (monthly payments) = $429.67 (these are the monthly payments that are made on the loan)
- FV (future value) = ??? (this is what we are solving, we want to see the balance in 5 years)
The answer is $81,403.01. Meaning that if Kurtz got a $90,000 mortgage, amortized for 30 years at 4%, but due in 5 years, then the balance due in 5 years would be $81,403.01. BTW, this is also a way to calculate loan balance.
3. A Lost "Exit"
What is the problem with this deal? In the first scenario there were 3 “exits” from the deal: 1. Sell, 2. Refinance, 3. Let the tenant pay off the loan ("pay & wait"). However, in the deal with the balloon the "pay & wait" option has been taken away, and the first two “exits” are all that are left, and those two are much more susceptible to market fluctuations.
If Kurtz decides to sell, the property value can’t drop below $81,000 (actually closer to $90,000 to account for closing and commissions). So, if the market does drop, then he will be in trouble and will likely have to come out of pocket to close the sale or perform a short sale.
If Kurtz wants to refinance, the market value of the property needs to be around $110,000 - $120,000 as many lenders want to have a loan to value of around 75% for a refinance.
By removing the "pay & wait" option that was available with the fully-amortized loan scenario, the deal becomes much riskier. With "pay & wait" the market drop did not affect him greatly as he could simply keep making payments from the rents collected. With the other two options, Kurtz is worrying about where the market will go, and hopes that there is not a dip, or else he will likely have a foreclosure on his hands. If there is no dip and property values go up, no problem, However, like I said before, as investors we want to remove as much uncertainty as we can by removing as much dependence on the market as we can, and when we have a balloon we make ourselves extremely dependent on the direction of the market, which is not good.
While real estate historically rises over the long term, it has had some pretty crazy crashes in the short term. Evidence of this is there are properties today that still do not sell for their price in the mid-2000’s. While we want to take every opportunity to get the ups that real estate provides, we also want to take care to avoid the crashes that can come with investing in a speculative manner. In my opinion, investing with a balloon mortgage is one of the most speculative and risky acts that can be made with an investment. So, make every effort to make sure that balloons stay at the circus and out of your mortgages.
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