What is a Balloon Payment in Contract for Deed
In contract for deed financing it is common to have a balloon payment, which is a set date when the remaining loan balance (including principal payments) is due from the borrower. Since sellers are individuals, and not large corporations like banks, it is not practical on say a 30 year fixed loan for the person lending you money to carry the loan that long.
Thus, why balloon payments are used. It defines the length of time a seller is willing to lend you money, but on the flip side as the borrower you can still enjoy a low monthly payment by obtaining loans amortized out as long as 30 years.
Clearly, it is not practical for 99% of borrowers to pay cash to the seller on that large of a remaining balance. This is why it is important for borrowers to have a game plan before entering a contract for deed on how they plan on obtaining bank financing in the future.
Balloon terms tend to range 3 to 5 years, which is a plenty of time for someone to fix their credit (or whatever is preventing you from getting a bank loan), and it is highly recommended to work with a mortgage lender/credit restoration company as early as possible. As long as the borrower knows this before obtaining contract for deed financing the balloon payment should never be an issue.
Here is a example loan scenario using $200,000 as the purchase price with 20% down payment on a 4 year term:
- Starting loan amount (purchase price minus down payment) equals $160,000
- At the end of 4 years after making monthly principal & interest payments the remaining loan balance could be $152,000, which is the amount that would need to be refinanced into a bank loan.
- Keep in mind the home may have appreciated quite dramatically in 4 years. With that much equity the borrower could just look at a simple refinance, or even look at a cash out refinance to get some additional cash at closing.
What Happens if I Miss the Balloon Payment?
Legally the seller lending you money has the right to cancel the contract for deed, take the house back, and you would lose everything along with your down payment. It is always possible the seller would be willing to extend the contract and give you more time, but there will never be any language in the original contract for deed allowing this. Borrowers should take the balloon payment seriously then.
Rather than lose the entire down payment and principal payments made by missing the balloon date; borrowers would almost always try to sell their home to profit from increasing house prices and retain the money they put into it. As long as the borrower is mindful of the balloon date it does not have to end with losing the home.
Therefore, as mentioned above it is critical the borrower understands what a balloon payment is and has a game plan for obtaining a bank loan. Contract for deed financing is not meant to be a long term financing solution, but rather a bridge for borrowers to achieve home ownership while they work towards qualifying for a bank loan. Make sure the balloon payment term matches with how long it will take you to get bank financing, and then if possible give yourself even more extra time as a back up plan.
Balloon Payment Versus ARM's (adjustable rate mortgage)
Some sellers will do ARM's 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 person lending you money fails to mention is just how much higher the monthly payment could increase once the date has been reached. 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.
The seller also is not required to follow any official protocol sending you notices for how much the monthly payment is going to change either, so unless you personally are staying up to date on interest rates most likely the change in monthly payment will come as a shock. All of this creates a cloudy situation for the borrower where most likely they are still going to try and get bank financing before the ARM resets or risk everything.
With a balloon payment the borrower knows exactly when they need to refinance. Their monthly payment is fixed and can never change during the loan period. Lastly, there should be no pre-payment penalty in a contract for deed. This means the borrower can refinance at any time (or make extra monthly payments) any time without penalty.
This is why a balloon is still preferable over an ARM, and ultimately 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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Listing information last updated on September 26th, 2017 at 10:24am CDT.