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The 5 Best Ways to Avoid a Balloon Payment
Seeing a commercial loan balloon payment on the horizon can be stressful, especially if you don’t have a clear plan. Find out the five best ways to handle balloon payments.
Image by Siora Photography from Unsplash.
Many types of multifamily real estate financing options include a balloon payment at the end of the term. While that final payment may be far higher than your average monthly debt service costs, there generally isn’t much cause to worry — provided you have planned how to handle it.
Read on for more information about balloon payments and, critically, how you can avoid them, or at least minimize their impact on your multifamily real estate investment strategy.
What Is a Balloon Payment?
A balloon payment is the natural consequence of having a loan with a term shorter than its amortization period. It is a large, lump-sum payment made at the end of a loan's term. It is typically made in conjunction with a loan that has a shorter term than the borrower's overall repayment timeline, and it is often used to lower the borrower's monthly payments during the loan's term.
The balloon payment size is determined by the amount of the loan's remaining principal balance, and it must be paid in full for the borrower to satisfy the loan.
Want to figure out the size and scope of your balloon payment? Enter your loan details directly into our calculator.
How to Avoid a Balloon Payment
Of course, it’s unlikely most borrowers make massive, one-off payments at the end of a loan to satisfy this requirement. So, what can you do to handle this final debt expense before retiring your mortgage?
There are a few ways to avoid a balloon payment when taking out a loan. We’ll explore each with its advantages and disadvantages.
Pay the Balloon Payment Before the Loan Matures
Yes, it’s obvious, but if you simply pay the balloon payment in advance, you’ll technically avoid it — but you’ll still be out a hefty amount of cash. Most partially amortizing loans do have prepayment penalties in place, though, so it’s unlikely you will be able to pay too far in advance without extra costs.
The majority of balloon loans waive prepayment penalties for the last 90 days of the term, however. With that in mind, you may be able to split your balloon payment up into a few more reasonably sized chunks if you can afford to do so.
Negotiate With Your Lender
It’s always healthy to have a good relationship with your lender. It’s especially worthwhile when you have a large balloon payment looming. Talk through your options with your lender and see what’s on the table. They may be willing to extend the term of your loan. While this doesn’t really avoid any balloon payment, kicking the can down the road a bit can give you extra time to figure out how best to proceed.
You may also be able to negotiate making larger payments toward the principal earlier on in the life of the loan, thus reducing the end-of-term balloon payment. Again, as mentioned above, there are often prepayment penalties associated with balloon financing, whether it’s a partially amortizing or interest-only loan, so don’t assume you’ll be able to do this without some kind of additional cost.
Refinance the Loan
One of the most common ways to handle a balloon payment is to simply refinance the loan. The new loan pays the balloon payment, and you’re either left with a fully amortizing loan — with no balloon involved — or at least a completely new timeline.
The big downside to refinancing now? Interest rates, simply put. If you took out a loan at a relatively low rate, odds are refinancing may not seem so attractive now, especially as rates are poised to climb even higher. Don’t assume refinancing would be a disaster, though: There are many competitive loan programs that are able to lock in relatively low, fixed rates. Sure, any new loan will bear a higher interest rate than it would have just a year ago, but waiting is likely the bigger gamble.
Sell the Property
Of course, you could always sell the property and use the proceeds to pay off your outstanding balloon payment. Investors often align their holding timelines with the end of their loans, and for good reason — it avoids the need to refinance or pay a huge amount of money out of pocket.
Selling your asset may not be so simple, however. If your property has depreciated, you may find that the sale proceeds can’t quite cover the remaining loan principal. While it’s far more likely your building has grown in value, even that may not be enough. Consider the current commercial real estate climate right now. Property values are generally faring well, but financing costs have jumped. It may be difficult to find a buyer willing or able to finance the acquisition of your asset.
Default on the Loan
This is far and away the worst option. If you’re investing in multifamily real estate, you want to maintain an excellent credit history, and this has the potential to undo all of that — and it could make your life very difficult.
That said, even if it’s a bad one, it is technically an option — and if your loan is non-recourse, at least you, personally, are not on the hook. This really should be a last resort, however, and it generally doesn’t make sense to default unless your property has significantly decreased in value — to the point where it’s worth well under the amount of your loan’s principal.
Image by Alexander Grey from Unsplash.
The Bottom Line
While an upcoming balloon payment can be daunting, remember the benefits you’ve received from this financing structure. Because the amortization exceeds the loan term, you have been able to make smaller monthly payments through the life of the loan. That’s helped improve your property cash flows and your bottom line.
And as for handling the balloon payment? For most investors, it just comes down to a willingness to refinance, sell, or negotiate. However, as with any investment strategy, planning is key. Know your balloon payment’s size and when it’s due to ensure you’re avoiding any surprises.
If you’re not planning to sell, refinancing is generally the best way to move forward. Yes, rates may not be appealing right now, but reach out to our team through the form below for a free quote. After all, waiting has its own cost when it comes to multifamily real estate finance.
Related Questions
What are the benefits of avoiding a balloon payment?
The main benefit of avoiding a balloon payment is that it can help improve your property cash flows and your bottom line. By avoiding a balloon payment, you can make smaller monthly payments through the life of the loan, which can help you manage your finances more effectively. Additionally, avoiding a balloon payment can help you avoid any surprises when it comes to your loan payments.
For more information, please see this article from Multifamily.Loans.
What are the risks of taking out a balloon payment loan?
Taking out a balloon payment loan can be risky. Defaulting on the loan is the worst option, 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, balloon payments can be difficult to manage, as they require a large, one-off payment at the end of the loan. Source and Source.
What are the alternatives to a balloon payment loan?
There are several alternatives to a balloon payment loan. One option is to refinance the loan with a longer term loan. This will reduce the monthly payments and spread out the balloon payment over a longer period of time. Another option is to negotiate with your lender to extend the loan term and reduce the balloon payment amount. Finally, you could consider a loan with a fixed rate, which will provide more stability and predictability in your payments.
For more information, please see 5 Methods for Handling Balloon Payments.
What are the most common types of balloon payment loans?
The most common types of balloon payment loans are 5/25 loans and 7/23 loans. A 5/25 loan has its principal and interest payments calculated based on a 25-year amortization, but the loan becomes due in full at the end of the last month of the fifth year. A 7/23 loan has its principal and interest payments calculated based on a 23-year amortization, but the loan becomes due in full at the end of the last month of the seventh year. Balloon payments are common financing vehicles in commercial real estate. This article provides more information about balloon payments and how to handle them.
What are the best strategies for avoiding a balloon payment?
The best strategies for avoiding a balloon payment are to negotiate with your lender and make larger payments toward the principal earlier on in the loan's term. Negotiating with your lender may involve extending the term of the loan, which can give you extra time to figure out how best to proceed. Making larger payments toward the principal earlier on in the loan's term can reduce the end-of-term balloon payment, however, there may be prepayment penalties associated with balloon financing.
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What are the most important things to consider when taking out a balloon payment loan?
When taking out a balloon payment loan, it is important to consider the following:
- The length of the loan term
- The amount of the balloon payment
- Any prepayment penalties associated with the loan
- The ability to negotiate with the lender to extend the loan term or make larger payments toward the principal earlier on in the life of the loan
For more information, please see 5 Ways to Avoid a Balloon Payment and The Benefits and Risks of Interest-Only Loans in Commercial Real Estate.