What Is A Balloon Payment In Contract For Deed
Example Loan Scenario
To illustrate how a balloon payment is used in contract for deed we will use a theortical loan scenario:
Purchase Price = $200,000
Down Payment = 20% ($40,000)
Loan Amount = $160,000
Monthly Payment = $1,091.48
Financing Terms = 7.25%, 30yr, 4yr balloon payment
Loan Amount End of 4 Years = $153,073.79 Due
99% of borrowers will need to refinance into a bank loan such as FHA or Conventional financing by the end of 4 years
Clearly, it is not practical for the majority of borrowers to pay cash in the remaining loan amount shown above. It is therefore critical to understand what a balloon payment is and have a game plan before entering a contract for deed on how to obtain bank financing in the future.
Contract for deed financing is not meant to be a long term financing solution
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 carying the loan, which presents a challenge when specifically looking at the length of loan.
Going back to the example above a 30 year ammortizion is used, which creates a very long time for someone to carry the loan. Banks make thousands of these at a time, so this type of situation is irelevant.
For a individual person however it is just not practical to hold the loan this long.
Thus, why balloon payments are used. It defines the length of time a seller is willing to carry the loan, but on the flip side a low monthly paymen is still achived with a 30 yr. It creates a win-win for both sides.
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 borrowers 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 borrower is not able to make the higher monthly payments once the ARM resets they will default on the loan, and the seller still takes the house back.
It is for this reason that many times the increased monthly payment comes as a shock to the borrower with no warning. With a balloon payment there is no confusion on when the borrower needs to refinance. It is more transparent then an ARM in this way.
The monthly payment is also fixed and can never change during the loan period. This is why a balloon is still preferable over an ARM.
In conclusion, it is as simple as the borrower ensuring they can refinance within the defined loan period. As long as this is the case home buyers should not see a balloon payment as any reason to avoid contract for deed financing.
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