What Does Balloon Payment Mean In Real Estate?
A balloon payment is a financing term specific to contract for deed, which is a way for the seller to determine how long they are willing to provide financing to a buyer. A typical range would be three to five years, which is when the remaining loan balance is due from the buyer.
Why Are Balloon Payments Used In Minnesota Contract For Deed?
A balloon payment is used in contract for deed, because unlike banks an individual homeowner is financing the buyer.
It is common for example to use a 30-year mortgage in real estate, which is how many years it would take to repay the loan. For banks this is not an issue, but for a seller they would be obligated to finance the buyer for the full 30 years.
This is not very practical for a homeowner willing to do a contract for deed. A compromise then is formed with a balloon payment. It defines the length of time a seller is willing to carry the loan, but it also achieves a low monthly payment for the buyer creating a win-win for both sides.
Most Buyers Refinance Or Sell By The Balloon Payment Date
The advantage of doing a contract for deed is the ability to achieve homeownership while a buyer fixes their credit, or other bank mortgage qualifications that resulted in a loan denial.
At the end of the balloon date the remaining loan balance must be paid off. With most balloon payment terms ranging up to 5 years, this gives plenty of time for most buyers to refinance into a bank loan such as an FHA or conventional financing. The refinance process is no different between a mortgage and contract for deed, which is very advantageous to the buyer when it comes to closing costs.
Similar to a mortgage there should never be a pre-payment penalty with contract for deed financing such as our no credit check home loan program. What this means is buyers can refinance at any time without incurring penalty fees from the contract for deed seller.
The other advantage of doing contract for deed is in the event a buyer can not refinance by the balloon date they can always sell the home. This allows the buyer to recoup their down payment, monthly principle payments, and even any increase in home value.
Also, many homeowners may be willing to do a contract extension if payments have been made on time.
Minnesota home buyers should then think of contract for deed as short-term financing to achieve home ownership with the goal of refinancing into a bank loan.
Balloon Payment Versus ARM (Adjustable Rate Mortgage)
An adjustable-rate mortgage (ARM), also known as a “variable rate mortgage”, is a loan where the interest rate periodically changes depending on the terms of the contract ranging anywhere from 1 to 5 years.
This can be misleading as buyers believe that an ARM is a safer product, because the balloon payment has been avoided.
What the seller fails to disclose in most cases to the buyer is how much the monthly payment could increase once the ARM resets to the new interest rate. If the buyer is not able to make the higher monthly payments, they may default on the loan.
There is no confusion on when the buyer needs to refinance or sell the home with a balloon, and the monthly payment will never change as it is on a fixed interest rate. A balloon payment is more transparent versus an ARM and in most situations the preferred choice.
In summary, a balloon payment in real estate is a way for the seller to define the length of time they are willing to finance a buyer. To have a successful transaction it is important the buyer begins working with a mortgage professional early in the process towards a refinance.
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