How To Set Up Your Real Estate Contract For Maximum Safety and Value

Part 5 – Using Balloon Payments

Extended payouts (“long amortization”) and low interest rates mean low value (big discounts) for your contract.

However, long payouts and low interest rates also make it easier to sell the property, because those two factors mean lower monthly payments for the buyer. You have to balance what is good for the value of your contract … short term and high interest rate … with what your buyer would like … long term and low interest rate. Properly used, “Balloon Payments” and “Bump Payments” can be used to increase the value of your contract while at the same time enabling you to keep the payments affordable to the buyer.

A “Balloon Payment” is a large, final payment that pays the contract off in full. A “Bump Payment” is a payment that is substantially larger than a regular monthly payment. However, unlike a balloon payment, a bump payment does not pay the contract off in full. For example, if the regular monthly payment on a contract was $100, you might call for an additional $1000 payment to be made every year. The $1000 payment would be the “bump”.

Balloons have to be approached with caution, because, if included, you have to be reasonably certain that the buyer will have the ability to come up with the money to pay the balloon. This is where knowing your buyers credit and income will help you determine their ability to pay the balloon. Further, the type of property you are selling will have a significant impact on the likelihood the balloon will be made. It’s difficult to get a loan on a non-conforming property, such as old mobile homes or vacant land. In the vast majority of communities in New Mexico, it will be practically impossible for the buyer to find conventional financing on an old (1980 or earlier) mobile home without 30% equity. If you received 10% down payment and amortized the contract for thirty years, but scheduled a balloon payment in 5 years, there is almost zero chance that the buyer will be able to borrow enough to pay your balloon. Therefore, you would either have to repossess the property, extend the contract, or hope the buyer had another way to obtain the money to pay the balloon.

Here is a typical clause that includes a balloon payment at the end (Assume the property sold for $30,000, had $3000 down payment, and $27,000 was amortized over 30 years at 10%)

“The balance of $27,000 will be payable in equal monthly installments of $236.94, such monthly payments to include principal and 10% interest. The first monthly payment shall be due and payable on the First day of February, 1998, with like payments due on the First day of each and every month thereafter. BALLOON PAYMENT DUE DATE: On January First, 2003, the entire remaining principal and accrued interest will be due an payable in full”

In this example, if the buyer pays all payments on time, when the balloon comes due on January 1st, 2003, that buyer will have to come up with about $26,312.34 to pay off the balloon. As you can see, they’ve paid less than $700 toward the balance of the loan, which is typical of contracts with a long payout. That means that 5 years after you created the contract, the buyer has to qualify for the same amount that they would have had to qualify for on day one. If the property and/or the credit of the buyer is non-conforming, your buyer must have some other way of paying the balloon.

Now, suppose you included the following clause in the contract the above:

“In addition to the regularly scheduled monthly payment, a payment of $1000.00 shall be made by purchaser on the first day of each and every year. The first such additional payment shall be made on January 1st, 1999, and another like payment on the first day of each and every year thereafter. BALLOON PAYMENT DUE DATE: On January First, 2003, the entire remaining principal and accrued interest will be due an payable in full”

Using this payment schedule, the balance of the contract will be about $21,000 when the balloon comes due. It is far more likely that your buyer can get financing for this amount, even with a credit or property problems. Buyers can budget for bump payments, but they can’t budget for balloons. By systematically paying down the balance of the contract, the chances of refinancing to payoff the balloon are dramatically increased.

You can protect yourself from having to deal with purchasers who are continuously late by including a balloon. You can also build in “inflation protection” by using balloons. Here is an example of a clause that you can use in scheduled balloon payments:

“Providing that not more than 2 payments have been received by the Escrow Agent more than 5 days after that payments due date during any consecutive 12 month period, Seller agrees to re-amortize the remaining principal balance and accrued interest over a period of ninety months at an interest rate of 14%. If more than two payments have been 5 days or more late during any consecutive 12 month period, the entire remaining principal and accrued interest shall become due and payable on the BALLOON PAYMENT DUE DATE.”

This clause works well because it give incentive to the purchaser to make timely payments while giving them some measure of protection from losing the property if they can’t make the balloon payment. The “conditional balloon” interest rate increase helps the value of your contract. It also gives you the option of calling the balloon due an a habitually late buyer.

In summary, from the standpoint of safety and value, a balloon payment should only be included if it is reasonable to assume that the balloon payment can be made. If a balloon payment comes due and it is eighty or ninety percent (or more) of the original sale price, the value of the contract is reduced. Contract buyers understand the difficulty of collecting large balloons, and adjust their offering price to reflect the increased risk of non-collection. If the balloon payment due is 70% or less of the original sale price, value is increased.