Balloon Payment Mortgages – Investors Beware!
Balloon payments are one of the most dangerous types of mortgages in real estate.
I either avoid them or use them very carefully in my real estate investing.
So, what is a balloon payment?
I’ll start by comparing it to a normal mortgage.
Normal vs Balloon Mortgages
A typical residential mortgage “amortizes” over 30 years. You make your minimum payment each month, and in 30 years the balance on the debt is $0.
A balloon mortgage could also have the same monthly payment. But sometime before the 30 years is up – like 5 or 7 years – your lender would require you to pay the full balance owed.
This would mean you need to come up with a HUGE amount of money either by refinancing, selling, or using your own saved cash.
For example, let’s say you borrow $300,000 at 7% interest with a payment of $1,995.91/month.
With a 5-year balloon mortgage, you’d need to come up with $284,042 at the end of your fifth year.
The Danger of Balloon Mortgages
I don’t like balloons because your wealth could be at risk if the balloon pops and you can’t pay it off.
You may think you’ll be able to refinance or sell because you always have.
But what happens if there’s a crisis in the mortgage market (like 2008-2009)?
Most normal lenders wouldn’t make loans during that time, and any buyers would only pay very low prices.
Instead, it’s wiser to assume you WON’T be able to refinance or sell. At least, not in a short period of time or for full price.
And this has led me to some practical rules I follow when it comes to balloon mortgages.
Rules for Balloon Mortgages
If I do agree to borrow money with a balloon mortgage (which I have), I like to follow these rules before I move forward:
1. Borrow a low enough loan balance that I could pay it off by selling or borrowing at a wholesale price
This usually means 70% of a property’s value or less. If I had to sell quickly to another investor or borrow from a private lender, this margin or safety gives me a better chance.
2. Push the balloon as far into the future as possible
A balloon payment 10 years or more into the future gives me enough time to plan and prepare for how to pay it off. It also gives me more time to hold through real estate market cycles.
3. Negotiate an ARM instead of a balloon
An adjustable rate mortgage (ARM) means your interest rate could go up or down in the future.
While I don’t like that either, I’d rather have an ARM than a balloon. If the interest rate goes up, you could bleed negative cash flow for a while and eventually solve the problem.
4. Avoid personal guarantees
Most mortgages have a personal guarantee, which means a lender can go after your personal assets if they lose money on their loan to you.
But with private lenders and certain commercial lenders, you can negotiate to NOT have a personal guarantee.
If you’re going to agree to a balloon, try to negotiate having the personal guarantee removed. If the lender won’t do it at first, offer to reduce the loan amount until they will.
5. Limit the number of balloon mortgages I have
As I understand it, Dave Ramsey went bankrupt when his commercial lender made him make balloon payments on millions of dollars of debt.
This negative experience led him to start his “avoid debt” education empire.
When I heard his story, I didn’t avoid debt. I just avoided BAD debt with balloons.
If I do borrow mortgages with balloon payments, I keep them as a small part of my overall portfolio so that I don’t run into the challenge of MANY balloon payments coming due all at once time.
Zero Risk Investing?
I have known several real estate investors who went out of business. In all cases, the cause was risky financing like balloon payments.
You can’t eliminate ALL risk from investing. That’s part of the game.
But you can reduce your risk by avoiding or minimizing risky debt, like balloon payments.
By doing this strategically, you’ll stay in the game longer and sleep better at night!
If you want more first-hand advice from me on financing your real estate investments, consider joining my private community Rental Property Mastery.
It’s only open to intermediate or advanced investors who’ve done at least one rental investment. And we’re getting closer to our cap of 300 members, so I hope you’ll check it out soon.