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November 17th, 2009 by Dawn Rickabaugh
Deadly Mistake #5: Create a short-term balloon
Because of the Time Value of Money (TVM), which says that money to be received sooner is more valuable than money to be received later, it can seem like putting in a 5 year balloon is a good thing. No need to wait 30 long years for payoff, right?
In previous markets, this made a lot of sense. The market was going up, and financing was cheap and easy to get. It was simple to refinance. But now it’s a different story, isn’t it?
A balloon only adds value to a note when there’s a clear and obvious exit strategy, which means easy, available and cheap financing laying around for the Payor to scoop up (or evidence that they have the cash to pay it off).
So, you have this balloon . . . what’s going to happen 5 years down the road if property values have decreased? What if interest rates are high? What if something has happened to the buyer’s (Payor’s) credit score?
They probably won’t be able to refinance and pay you off, so now you’re stuck with either restructuring the note, or foreclosing and taking the property back.
Most note buyers these days buy a note with a balloon anticipating that they’ll end up restructuring the loan and extending the repayment period, which decreases the return (which means they’ll need to buy it at a steeper discount than you would normally think, based on the calculations of your nifty little HP).
Smart tip: Fully amortize your note over the shortest time period possible . . .
Can the buyer afford a 15-year amortization? Or a 20? When a note is fully amortizing (meaning it’s completely paid off by the end of the term), we don’t have to worry about the buyer’s future ability to refinance a balloon payment.
If you’re going to ask for a balloon, push it out to 7, 10, or 12 years. The longer we have for the real estate and credit markets to stabilize, the better.
Investors will think . . . “OK, things are not great now, but I’m pretty sure in 10-12 years the market will have recovered and we’ll be in a better situation. By then, this Payor should have no trouble refinancing, especially since the principal balance on the note will be a lot smaller.”
Another idea is to ask for Stepped Payments. This is where the interest rate remains the same, but the monthly payment due from the buyer increases by a certain amount or percentage every year. This leads to a faster pay down of the loan balance.
Stepped Payments also provide seniors, who are often on fixed finances at retirement, a stream of income that helps them deal with inflation, and the reduced buying power that their money will have with each passing year.
P.S. Avoid ‘interest-only’ loans . . . no one wants to buy them!
This excerpt is taken from “Seller Financing on Steroids: Pumping Paper for Power, Peace and Profits,” a guide that can be downloaded for free at: www.NoteQueen.com.
Always consult with your CPA, tax attorney and/or financial advisor before selling property or paper.
Dawn Rickabaugh is a RE broker with expertise in seller financing and RE notes (trust deeds). www.NoteQueen.com 626.641.3931