What Does Balloon Payment Mean in Real Estate?
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 3 to 5 years, which is when the remaining loan balance is due from the buyer.
The majority of buyers will need to refinance into a bank loan such as FHA or Conventional financing by the balloon payment date
First, it is not practical for the majority of buyers to pay cash on the remaining loan amount at the end of their term. Home buyers should think of contract for deed as short term financing in order to achieve home ownership while working towards refinancing into a bank loan. Begin the process early with a lender and/or credit repair company, and then match the balloon payment term (example above 4 years) with how long it will take to get bank financing.
Why is a Balloon Payment Used in Contract for Deed?
The main reason why balloon payments are used in contract for deed is unlike big banks an individual is the one carrying the loan, which presents a challenge when specifically looking at the length of loan.
It is common for to see 15 and 30 year mortgages in real estate financing, which is how long the loan is. For an individual seller however this is a very long time to carry the loan.
It is just not practical to hold the loan this long from a seller’s perspective, but for a buyer where a 30yr. mortgage is the most popular loan type it is advantageous to achieve the lowest monthly payment.
A compromised is formed then with a balloon payment.
It defines the length of time a seller is willing to carry the loan, but on the flip side a low monthly payment is still achieved for the buyer with a 30 yr. It creates a win-win for both sides.
Balloon Payment Versus ARM’s
Some sellers in a contract for deed will do ARM’s (adjustable rate mortgage) instead of a balloon, which can follow a similar term period (3 to 5 years). This can be very misleading for buyers as they believe that the balloon payment has been avoided and an ARM is a much safer product.
But what the seller fails to disclose many times is just how much higher the monthly payment could increase once the ARM resets to a higher interest rate. If the buyer is not able to make the higher monthly payments once the ARM resets they will default on the loan, and the seller can take the house back.
There is no confusion on when the borrower needs to refinance with a balloon payment. It is more transparent then an ARM in this way, and in most situations is going to be 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 financing a buyer. In order to have a successful transaction it is important the buyer begins working with a mortgage professional early in the transaction towards a refinance.
There should never be a pre payment penalty with contract for deed. As long as the buyer clearly understands what a balloon payment is, and how it works, a contract for deed can be an excellent way for a buyer to achieve homeownership when bank financing is not an option.
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