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What’s Better, A Balloon Note Or Stepped Payments?

A Balloon Note Or Stepped Payments?

By Robert Duplicki      March 3, 2021

BALLOON NOTE- A promissory note made part of a purchase agreement, such as a mortgage, that includes a lump-sum payment. This is the final payment, and pays the remaining money owed, so it is larger than a typical monthly payment.

STEPPED PAYMENTS- Financial payments that increase gradually over time. They are also part of a financial document that includes a promissory note.

Both balloon notes and stepped payments offer flexibility in their design. They also provide buyers and sellers of various assets, a creative way to meet current and future needs.

Other articles and aspects of NoteSolutions.us deal with seller financing. Much of this applies to balloon notes and stepped payments. Seller financing is the approach where you are likely to find these techniques applied.

A basic example of a balloon note could involve an asset being sold for $100,000 at 5% interest with a $20,000 down payment. The seller wants all their money within ten years. The buyer needs smaller monthly payments.

With a ten year term these numbers result in a monthly payment of $848.52. A thirty year term results in a monthly payment of $429.46. As a compromise, the buyer and seller might agree on a thirty year term with a ten year balloon. The monthly payments will remain at $429.46, amortized over thirty years. A balloon payment of $65,073.65 will be due in ten years.

This may or may not work for you, but it’s a technique worth having in your tool box.

When an example like that above works, and why, will vary. How motivated is the seller and the buyer? What has changed in their lives and what new opportunities have arisen?

For a more extreme example, let’s say a handyman business operator wants to invest in property. In his travels he keeps seeing a run down house in a location he likes. Much debris removal is needed inside and out. He discovers that the owner has passed, and the property was inherited by the family who live out of town.

The handyman has a source of funds to rehab the property, and he plans to rent it out afterwards. His credit is ok but he isn’t ready to talk to a bank, and the condition of the house would make bank financing difficult anyways.

The family would prefer to be relieved of all responsibilities regarding the property, yet doesn’t have an urgency to receive cash for it. They also have a mutual acquaintance with the handyman who attests to his complete trustworthiness.

To handle all work required to get this house rented, while running his handyman business, will be a large undertaking before receiving any income. He can only afford to do this by making no payments to start.

The inherited owners and the handyman agree on a purchase price of $20,000, at 6% interest, and a balloon payment for the total due in seven years. The balloon payment will be $30,407.39.

The new owner’s plan is to do all work necessary to prepare the house for rental. During that time he will pay the taxes and insurance and handle all ongoing responsibilities. He will pay for the cost of rehab from the rents, and hopes to be earning a profit before refinancing to make the balloon payment.

While many property sellers wouldn’t be interested in making such a deal, you can see how this approach works for this buyer and seller. Seller financing allows you to utilize creative arrangements that work for your circumstances.

Do Investors Purchase Notes Having Balloons?

Yes they do! So this provides another option for a property seller deciding whether to accept a balloon note. Just like offering seller financing using a straight note, their exit strategy may include the thought that they won’t have to hold the note to maturity, if they don’t want to.

Likewise note investors have options too as they consider purchasing a balloon note. The starting point is the usual due diligence used to evaluate other notes. All the terms of the note itself, the features and condition of the asset securing the note, and the financial viability of the payor will be considered. So the related information that I’ve provided in the past, applies here as well.

However a balloon note has additional concerns. At a basic level the question is, if the note payor was in a financial position that required a balloon to start, why will they be able to qualify for a bank refinance when the balloon payment comes due? This may sound somewhat harsh, but a note investor is evaluating an investment. The note investor is not a motivated property seller or buyer.

Keep in mind that among the points mentioned here, one factor affects another. So you could reach a different conclusion about your own circumstances, than a note investor would while evaluating your note for purchase.

In general the sale of a balloon note may include the whole note, only the monthly payments, only the balloon, or a partia sale. The seller of the note may market the note with one of these options in mind. On the other hand, the note investor may only offer one option. Often the seller may not have such awareness ahead of time, and a note broker will present more than one type of offer.

The approach a note investor takes may vary based on the type of note. Residential financing commonly utilizes thirty year terms. Seller financers often want a faster payoff so they include a balloon payment. For a short term balloon, say five years or less, the note investor may only be willing to purchase the monthly payments, and leave the balloon payment for the note seller.

A longer balloon term has less risk of not being paid. In order to reduce the risk of not getting paid the note investor may only offer a partial purchase. As a partial typically reduces the discount, the note seller may prefer it anyways.

After the note payor establishes a longer payment history, the note investor will probably be interested in purchasing more of the note.

Business notes on the other hand, are often written for a term of five to seven years. The hope is that the business will be in a strong enough financial position to obtain bank financing at that point. But the term you agree upon should be based on what’s best for your situation. The concept of a balloon payment certainly makes sense here.

When you are selling a business note you will find that partial sales are most common. A purchase of up to 72 months is a likely maximum. Less is more common. Purchasing balloon payments are considered if the total months to amortize are less than 72. Once again, as the note payor establishes a longer payment history, the note investor will probably be interested in purchasing more of the note.

Balloon Note Tips

  • When a balloon payment is offered as part of seller financing, consider the strategy that you will sell the monthly payments and keep the balloon payment as an investment.
  • With the additional concerns of the balloon payment, the credit history of the note payor becomes more important in the eyes of the note investor. In the same way a property seller should be more vigilant about underwriting factors, before agreeing to a balloon note.
  • Under the Dodd-Frank Act, Three Property Exception, a balloon payment is not allowed. Under the Dodd-Frank Act, One Property Exception, a balloon payment is allowed (not less than five years recommended). For clarity refer to this Dodd-Frank fowchart.
  • Looking ahead to the final payment when the balloon is due, remember that interest is paid in arrears. So the monthly payments pay for the previous month’s interest. Therefore the final payment will equal the total of the last monthly payment plus the balloon payment.
  • Before a balloon note is agreed to, the buyer of the asset should have a plan for how the balloon will be paid. A back-up plan is also a good idea. For example, the buyer of a property may plan to sell it in order to pay the balloon. What happens if the property doesn't sell in time? What other source of funding can you arrange ahead of time? You could include a provision in the note that allows for an extension of the balloon due date. This could be based on an increase in the interest rate or the monthly payment, a partial payment of the balloon, or some combination thereof.

Stepped Payments

As mentioned above, stepped payments, also known as graduated payments, are financial payments that increase gradually over time.

For example, instead of paying the same monthly mortgage payment for thirty years, the payment increases annually by 5% per month, and you pay off the mortgage sooner.

Stepped payments can be used as part of financing for residential and commercial properties, businesses and equipment leasing. Within structured settlements they can be used to compensate for cost of living increases. And through amendments to the Civil Liability Act effective October 1, 2018, periodic payments can now be awarded in catastrophic personal injury cases.

Adjustments to stepped payments can be made in dollar increments, on a percentage basis, monthly, quarterly, annually, after X years of equal payments, and combined with a balloon to reduce the future balloon payment.

Of course the terms of seller financing are negotiable, and stepped payments add an excellent option. So between seller and buyer you can use the terms that match your cash flow.

BALLOON NOTE/ STEPPED PAYMENTS COMPARISON
Note Characteristics Straight Note Balloon Note Stepped Payments Combined Plan
Note Characteristics:Monthly Payments Straight Note:$1,498.88 Balloon Note:$1,498.88 Stepped Payments:$1,498.88 Combined Plan:$1,498.88
Note Characteristics:Balloon Payment Straight Note:0 Balloon Note:$209,213.77 Stepped Payments:0 Combined Plan:$176,362.57
Note Characteristics:Number Of Payments Straight Note360 Balloon Note:120 + Balloon Stepped Payments:224 Combined Plan:120 + Balloon
Note Characteristics:Finance
Charge
Straight Note$289,596.80 Balloon Note:$139,079.37 Stepped Payments:$185,614.31 Combined Plan:$133,228.17
Note Characteristics:Total Of Payments Straight Note$539,596.80 Balloon Note:$389,079.37 Stepped Payments:$435,614.31 Combined Plan:$383,228.17
Note Characteristics:Amortization Schedule Straight NoteStraight Note Amortization Balloon Note:Balloon Note Amortization Stepped Payments:Stepped Payments Amortization Combined Plan:Combined Plan Amortization
Terms:   Amount Financed: $250,000   6% Interest   360 Payments

Balloon Note/Stepped Payments Comparison

The chart above shows that a $250,000 note financed for thirty years at 6% interest results in a monthly payment of $1,498.88. This common approach is known as a straight note. Over the full term the total finance charge is $289,596.80 while the total payments are $539,596.80.

If a property or business seller is not willing to wait as long for a complete payoff, a ten year balloon provides one option. For the buyer who needs to keep monthly payments under $1,500.00, this can be achieved by amortizing the note for thirty years.

While the monthly payments stay the same, after ten years a balloon payment of $209,213.77 is due. This might be viewed as good news and bad news for the buyer. The payments are affordable but there is a large bill due in ten years. Often a balloon payment is made by refinancing the note, so there are refinance charges to consider.

There is more good news if the balloon payment can be made without refinancing. The finance charge has been reduced to $139,079.37 and the total of all payments was reduced to $389,079.37. This is a savings of $150,517.43 from the note paid in 360 payments. Even if the balloon payment requires a refinance, the payor of the note has a financial benefit to work with.

The third option in the chart utilizes stepped payments. Some sellers won’t want to deal with a balloon payment, and neither will some buyers. As an alternative to the straight note, stepped payments in this example, begin with the same terms.

In year one the monthly payments are also $1498.88. Beginning in year two, the monthly payments increase by $50.00 per year, for seventeen years. In year eighteen there are seven more payments by this method, and the final payment is a little over $800.00 more because of rounding.

Compared to the straight note, by using stepped payments the total number of payments is reduced from 360 to 224. The finance charge is reduced to $185.614.31 and the total of all payments is reduced to $435,614.31. This is a savings of $103.982.49 compared to the straight note.

While the savings are not as great as with the balloon note, they are still substantial. As many sellers and buyers and some note investors would rather avoid a balloon, stepped payments provide an attractive option.

Keep in mind the flexibility that sellers and buyers have to agree on the use of stepped payments that meet their needs. It may help the buyer to delay stepped payments for two or three years. A different dollar amount may work better for the seller. Or the stepped increases could be made on a percentage basis instead.

The fourth option in the chart above combines stepped payments with a balloon payment after ten years of monthly payments. The other terms of the note remain the same. Once again in year two the monthly payments increase by $50.00 per year.

The key benefit of combining stepped payments with a balloon payment, is a reduction in the amount of the balloon payment, plus a reduction in the total finance charge.

Compared to the balloon note option, by starting with stepped payments the balloon payment is reduced from $209,223.77 to $176,362.56. The total finance charge compared to the balloon note option is reduced by $5,851.20. The total of all payments is $383,228.17 which is the lowest of all the options presented.

Will This Work For Business Notes?

BDC is the Business Development Bank of Canada. In their own words, they are a “financial institution devoted to Canandian entrepreneurs.” Here is their definition of stepped payments:

"With a stepped-payment loan, a borrower’s monthly payments start low and increase gradually over time. This arrangement can be beneficial for start-up companies with limited financial resources in the beginning.

Stepped-payment loans are riskier than other loan types because it takes longer for lenders to get back their principal (the original amount of the loan). For this reason, lenders tend to only offer stepped payments to well-managed companies and on loans that are secured with high-quality assets–those easy to convert to cash."

So this is a brief look into a bank’s view of stepped payments. Their reference to the length of such a loan considers the typically shorter length of commercial financing compared to single family residential. Meanwhile bank loans used to purchase a small business are usually tough to get. And the comment that “stepped payment loans are riskier than other loan types” is of course relative.

Once again seller financing offers much more opportunity for buyer and seller to negotiate. While some of the insights offered by banks are helpful in structuring seller financing, you are not limited by the same restrictions.

My Business Notes page adds a lot more to this topic. Stepped paymnets fit right into that process. Stepped payments could be just what a business seller and buyer need to use to put a deal together. But they could result in a longer note than the seller wants, or a higher monthly payment than the buyer can afford. In order to sell the note the business seller should be prepared to accept a partial sale. But that is common for the purchase of business notes. And stepped payments provide an opportunity to avoid a balloon payment. So what works depends on the needs of buyer and seller.

Conclusion

So what's better, a balloon note or stepped paymnets? My conclusion follows along with what I just said about using stepped payments for a business note. It depends. The great part is that seller financing allows you to decide.

References

  1. Photo by Faruk Melik ÇEVİK on Unsplash
  2. Business Development Bank of Canada
  3. Owner Will Carry, by Bill Broadbent,SEC,CCIM, & George Rosenberg, 1998

REFERRALS = CASH FOR YOU OR YOUR CHARITY

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