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5 Methods for Handling Balloon Payments
If you have a partially amortizing loan, you no doubt have a balloon payment awaiting you at maturity. Find out five ways of handling these lump-sum payments.
When you take out a loan to purchase commercial real estate, you will have to make periodic payments to the lender. These payments are usually made on a monthly basis, and they go towards both the principal of the loan and the interest.
However, some loans come with a balloon payment. This is a lump sum payment that is typically due at the end of the loan term, and it can be a significant amount of money. Balloon payments are not present on fully amortizing loans. But, if your financing — like many commercial real estate loans — has a shorter term than its amortization period, there is undoubtedly a balloon payment waiting. This amount must be paid before the loan matures.
Example of a Balloon Payment
For example, let's say that you take out a loan for $5 million to purchase a retail property. The loan has a term of 10 years, the interest rate is 5%, and it amortizes over 30 years. From this, we can determine, using a mortgage calculator, that the monthly payments would be approximately $27,000 ($26,841.08, for those with a need for details).
Because the loan isn’t fully amortizing, the monthly payments will not bring the loan’s principal down to zero during the term. In fact, there will be a significant chunk left to pay — close to $4.1 million, in this case. This is the balloon payment due when the loan matures.
Are Balloon Payments Good?
Many borrowers opt for partially amortizing loans with balloon payments, as they keep monthly payments significantly lower for shorter-term financing packages. Think of it this way: A five-year, fully amortizing loan would have monthly payments of about $19,000. That same five-year loan, amortizing over 30 years, would come in at around $5,400 per month.
That said, the balloon payment can’t be ignored. For many people, they can be a significant financial burden. In this article, we will discuss five methods that you can use to avoid having to make your balloon payment.
Ways of Avoiding a Balloon Payment
There are a few different ways that you can avoid having to make a balloon payment. Some options are better than others, but they depend on the borrower’s unique circumstances.
Put Money Aside Over Time
It makes sense to budget some money to cover an upcoming balloon payment well in advance. If you put an amount into a savings fund or any risk-averse, liquid investment every month, this ensures you will have the money ready when the time comes.
You could also potentially make larger loan payments throughout the loan’s term, but this may not be permissible. If your loan has prepayment penalties, this may not be the best option.
Get a Refinance
The most common way to avoid a balloon payment is to simply refinance. Provided you refinance your property within the time frame permitted by the loan (or are willing to pay any prepayment penalties) this effectively kicks the balloon payment further down the road.
Or, if you refinance with a fully amortizing loan, the new financing can remove it entirely. This would allow you to spread out the remaining balance of the loan over a longer period of time and avoid having to come up with a large sum of money all at once.
Talk to Your Lender
If you are having trouble making your monthly payments, you may be able to negotiate with your lender to avoid the balloon payment. You will still need to pay the money, of course, but your lender may be willing to negotiate an extension to the loan’s term, which will delay the inevitable — while also reducing the total balloon payment amount.
Sell the Asset
If you have a balloon payment coming due, you could avoid the payment by simply selling the property. The proceeds of the sale would then pay off the loan, including any balloon payment. This is a common method of handling a balloon payment, but timing is everything: If you’re forced to sell a property quickly because you didn’t plan well, you may not get the return you’re looking for on your investment.
Default on Your Loan
Defaulting is, hands down, the worst option you’ve got on the table. But it is an option, nonetheless. Keep in mind that most loans with balloon payments are non-recourse. This means if you are unable to make payments, the lender cannot tap into your personal assets or income streams. Only the property is on the hook.
That said, defaulting can be immensely damaging to your commercial real estate investment career. Significantly fewer lenders will consider extending financing to a borrower that has defaulted, which means any financing you get in the future will be far more expensive — and bear far poorer terms — than it would otherwise.
The Final Word
Balloon payments may be something a borrower dreads, but their existence allows for investors to make significantly smaller payments than they would otherwise be able to. And even though balloon payments can present a burden, there are plenty of ways to work around them, as described above.
The best strategy if you have a loan with a balloon payment is, above all, to be prepared. Which route you take is highly reliant on your individual circumstances as well as the property and market conditions involved.
Curious how a loan with a balloon payment would improve your cash flows? Fill in the form below, and we’ll be in touch.
Related Questions
What are the benefits of balloon payments for commercial real estate financing?
The main benefit of balloon payments for commercial real estate financing is that they allow borrowers to make smaller payments over a longer period of time. This can be beneficial for borrowers who may not have the cash flow to make larger payments. Additionally, balloon payments can help borrowers manage their cash flow more effectively, as they can make smaller payments over a longer period of time. Finally, balloon payments can also help borrowers save on interest payments, as the loan is paid off in a shorter period of time.
For more information, please see Investopedia's article on Balloon Payments and Commercial Real Estate Loans' article on Balloon Payments.
What are the risks associated with balloon payments?
The main risk associated with balloon payments is defaulting on the loan. Defaulting is the worst option you have on the table, as it can be immensely damaging to your commercial real estate investment career. Significantly fewer lenders will consider extending financing to a borrower that has defaulted, which means any financing you get in the future will be far more expensive — and bear far poorer terms — than it would otherwise. Additionally, most loans with balloon payments are non-recourse, meaning the lender cannot tap into your personal assets or income streams. Only the property is on the hook.
For more information, please see 5 Methods for Handling Balloon Payments and Is Non-Recourse Financing Right for You?.
What are the different types of balloon payments?
There are a few different types of balloon payments, depending on the borrower's unique circumstances. These include refinancing the loan, extending the loan term, making a lump sum payment, or selling the property.
Refinancing the loan involves taking out a new loan to pay off the existing loan, which can help reduce the amount of the balloon payment. Extending the loan term can also help reduce the balloon payment, as it spreads out the payments over a longer period of time. Making a lump sum payment can also help reduce the balloon payment, as it reduces the amount of the loan that needs to be paid off. Finally, selling the property can help avoid the balloon payment, as the proceeds from the sale can be used to pay off the loan.
For more information, please visit 5 Methods for Handling Balloon Payments.
How can I calculate the amount of a balloon payment?
You can calculate the amount of a balloon payment by using a commercial mortgage calculator. For example, if you take out a loan for $5 million to purchase a retail property with a term of 10 years, an interest rate of 5%, and an amortization period of 30 years, the balloon payment would be approximately $4.1 million.
What are the best strategies for managing balloon payments?
The best strategy if you have a loan with a balloon payment is, above all, to be prepared. You can also try to negotiate with your lender to avoid the balloon payment or extend the loan's term, which will delay the inevitable and reduce the total balloon payment amount. Additionally, you can consider refinancing, selling the property, or taking out a second loan to cover the balloon payment.
For more information, you can check out this article from Commercial Real Estate Loans.
What are the alternatives to balloon payments for commercial real estate financing?
Alternatives to balloon payments for commercial real estate financing include traditional amortizing loans, interest-only loans, and hybrid loans. Traditional amortizing loans are fully amortized over the life of the loan, meaning that the borrower makes the same payment for the life of the loan unless it is refinanced or paid early. Interest-only loans allow the borrower to pay only the interest on the loan for a certain period of time, with the principal due at the end of the loan term. Hybrid loans are a combination of the two, with a period of interest-only payments followed by a period of amortizing payments. For more information, see this article from Investopedia.