What does “principal balance” mean in regards to a balloon payment?

Question

Terms of a seller financing addendum, non-consumer credit transaction say, “Amortized over 10 years If balloon payment, principal balance due on or before 06/01/2035”.

Is this a trick to only pay the principal at the end and avoid the accrued interest?

Patrick Roberts · Answer

@Raquel Baranow What's your basis that you would pay cap gains on? Even if it was $0 and you sold for $130k cash, you would net around $105k cash (LT cap gains on $130k at 20%). If you used this $105k to purchase a note/make a loan with an 8% yield and 22 year amortization (the same amortization as what's implied in the addendum), you would get around the same $850/month in P&I payments. You could like do this with much less risk, though, as investment property loans with no downpayment have notorious default rates.

Since this door has already been opened, I would explore repairing it and seller financing it in good condition to a buyer at a near market price if the rehab isnt too crazy. In other words, if the rehab is $30k-$40k and youre already considering seller financing, then do the rehab and seller finance it for $200k at 7%+ for 30 years with a 10-20% downpayment. You could even keep the ten year balloon if you wanted. If the downpayment covered most of your rehab costs, then you would be no worse off than you are right now, but would be getting around $1,200/month in P&I for 30 years ($200k purchase, 7% rate, 10% down). Also, the unpaid balance at year ten would be around $150k, not $100k like in the current deal.

My guess is that your buyer is going to do exactly this - buy the house from you on terms, rehab it, and then seller finance it to a new buyer on a wrap at a much higher rate, all while getting a downpayment from the new buyer to extract most/all of the rehab cash. Your buyer would basically have no cash in the house and would collect $1,200-$1,500/month from their buyer, and then would pay you $850/month on your note. Ultimately, you still bear the default risk here, because there is a high likelihood that if the end buyer defaults, your buyer could easily walk if they need/choose to. They would have no capital in the deal by that point.

Food for thought. Either way, I would work the math on the opportunity cost. Option A is the net cash price today (the cash price minus taxes) reinvested at a yield of 8%-9% in a note/private loan for the next 20-30 years with a low/moderate default risk, and Option B is a net cash price of $165k today reinvested in note yielding 3% for the next ten years, with a payoff of about $100k at the ten year mark with a moderate/high default risk.

Patrick Roberts · Answer

Thanks for mentioning this. Do not seller-finance this at 3%. If for some reason you need to liquidate the note to generate some cash in the future, you will take a massive discount on the value of the note and would only get pennies on the dollar for it. Seller financing should bring above-market rates, not below-market rates. If the buyer wants prime rates, they can go to a bank.

I dont know if its a trick. I think the limited verbiage on the form may be creating part of the confusion. If the loan amortizes over ten years, then the balance at year ten should be $0. If the loan has a ten year maturity but amortizes over a longer period, say 25 years, then part of the loan will be unpaid at the end of the ten years. This leftover amount is the balloon payment - the amount due at the end of ten years is the remaining principal balance that has not be paid by the buyer yet. This second scenario is very common in commercial lending.

The buyer should be paying the accrued interest in monthly installments with the amount of interest owed based on the principal balance in each corresponding month. Do not accept or agree to have interest accrue and be paid at the maturity. If the loan is amortizing, then the buyer should also be making payments toward the principal each month in addition to the interest payment. The $850/month listed on the form should not include escrow/impound for taxes and insurance - that should be a separate amount because it will change over time - likely every year.

If youre the seller, do not let the buyer draft the documents or dictate the terms. Have an attorney who represents your interests draft the documents on your behalf and provide advice on the terms you negotiate with the seller.

Lastly, I'd recommend requiring a downpayment of at least 10%. Default rates are inversely related to downpayment - the lower the downpayment, the higher the probability of default.

Henry Clark · Answer

OP can’t see the full agreement. 1.  Did the contract require them to carry insurance and list you as “additional insured”?  Needs updated every year.  Clause- if they don’t, balance is immediately due.

2.  Property tax-  if they fail to pay, is there a clause balance is due?

3.  Do you have a lien recorded against the property?  That way it can’t get sold or refinanced without going thru you.  You want First position always.4.  Etc  etc etc

James Hamling · Answer

I am confused by the situation @Raquel Baranow.

If your happy to basiclly give it away to someone ($0 money down) for the purpose to flip it (that's exactly what these buyers are doing, right).......

Why wouldn't you just call up decent contractors in the area, and offer it to them. That you'll give it to them, no money up front, they can do the whole reno to make it sellable in retail condition, all reno on them.

The basis $ to you, is what these others are willing to pay. Then contractor get's all there expenses back, and what's left is split 50/50.

Simple.

A GC get's a "free flip", you both win.

Vs janky deals at 3%.......

Greg M. · Answer

Stones... glass houses...

Do you at least have a liability policy that would have covered you if it turned out to be your fault?

Jeff S. · Answer

“I’ll agree to your price if you agree to my terms,” is the golden rule of deals like this, @Raquel Baranow.  Don’t get backed into a corner.

I agree with @Patrick Roberts.  If you are going to sell at a price substantially below the market, even considering the smoke damage, ensure the terms are in your favor.  Selling at 3% interest amortized will leave you with nowhere to go if you want to sell your loan.

“Amortized over 10 years If balloon payment, principal balance due on or before 06/01/2035,” is not even English.  No wonder you’re confused.  So am I and I can’t believe the Arizona Association of Realtors would use this form.

If your buyer wants lower payments, consider making this an interest-only loan with a decent down payment and maybe a shorter term to maturity.  This would keep the principal balance unchanged over the term of the loan.  For example, an $850 monthly payment interest only is a 6.2% return on a $165k loan.  With a $20k down payment ($145k loan), a 10% or 12% return would require a $1208 or $1450 per month payment, respectively.  Was your rent below the market?  Run some numbers and don’t let your buyer set the terms.

Most importantly, I see where this is going: You’re going to use loan docs provided by your borrower.  Right?  Do you think they will be in your interest?  These should be written with zero ambiguity by your lawyer.  I know you really, really want to get out.  Do you know how hard it is to find good deals now?  You have something others really, really want.  I know it’s easy for me to say, but don’t roll over on this, Raquel.

Patrick Roberts · Answer

Oh boy. Based on the math and what's in the picture, this looks like a partially amortizing loan. On 6/1/2035, there will be a balloon payment of $103,863 using the figures in the addendum to calculate. If this loan was to fully amortize given a starting balance of $165k, note rate of 3.0%, and monthly P&I payments of $850.00, then it would take approx 22 years to pay off. This addendum shows that the loan terms out in 2035, long before 22 years.

I would get a copy of the note and the deed of trust to get the exact figures and agreement. This is just the addendum; the note will detail the actual terms of the loan.

Connor Hibbs · Answer

Principal Balance is in reference to the amount of money that was initially borrowed. This does not include the interest payments and is attached to the amount that needs to be paid off at the loan's maturity date/ when you want to exit the loan (excluding any additional interest that may have been accrued).

Chris Seveney · Answer

There is no accrued interest since they are paying it every month. A balloon payment is they pay it amortized over a longer period of time and at the balloon date they pay off the balance.

Theresa Harris · Answer

Get your lawyer to look at it and ask them.  If they don't like something, then get them to change it. Regardless, do not let them buy it with no  money down.

James also has a great suggestion of partnering with a good local contractor.

What does “principal balance” mean in regards to a balloon payment?

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