Balloon payments on commercial loans can have many benefits for both you and your lender.
How balloon payments works: You request a $500,000 loan to purchase real estate. The lender agrees to approve the request but due to the risk (from you) and the situation of the bank (its costs of funds, liquidity, structure, etc) will only approve a five (5) year term. At a five year amortization, that is huge monthly payment – probably to much for your business or something that will severely hamper your cash flow and cash management.
So, the lender says, to help you out here, we will amortize the loan over 25 years (reducing your monthly payment) but you will still have a sizable amount of principle remaining at the end of the 60 months (five years) that you will either have to refinance (with the current lender or a new lender) or pay off in full.
Under this scenario, your monthly payment would be $3,860 per month (at 8% for 25 years). However, at the end of the five year term (after 60 payments) you would still have an outstanding balance of $461,730 that would need to be refinanced or paid off.
Benefits for the lender:
1) They receive a lions share of interest as the majority of your payment goes to your interest charges early in the life of any loan.
2) They get to reevaluate your business’ health periodically (after the 60 months) to ensure that you are still willing and able to service their facility.
3) If they renew the loan, they get all the fees associated with the renewal.
4) If they don’t renew, then they have not put undue risk on their balance sheet.
Benefits for you and your business:
1) When the balloon is due, if your situation (your business’ health) has improved, you have more power to renegotiate the terms of the loan – getting lower interest and better payment terms.
2) Most commercial loans are set with variable rates, thus when the balloon is due, your company may be able to adjust rates down or seek a fixed rate.
3) If you don’t like your lender or find another that you prefer, this is a great time to move your loan somewhere else.
4) Lenders may look beyond their lending guidelines in approving your request as they are not risking their capital for extremely long terms – thus, you might be able to qualify if your credit is just a little bit shaky or you do not have 20% or 30% in equity or even your time in business does not meet their minimum.
5) Lower payments if the loan is amortized over 25 years – even though it only has a 5 year term. Example, A $500,000 loan at 8% for 60 month (5 years) your payment would be $10,139. If this same loan is amortized over 25 years with a five year balloon, your payments would be $3,860 (difference of $6,280 – nearly two- thirds lower and much more manageable).
Note: This does not mean that you only have to make the minimum payment each time. You can reduce your overall interest and term (assuming simple interest) by paying more when you can. The good thing about this is that if you can pay more do so, if not, you are not stuck with that $10K payment – gives you the flexibility to better manage your cash flow.
So, even though these are odd instruments, they may hold some benefit to you and your company.
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