Unlike traditional residential 30-year mortgages that fully-amortize in equal payments throughout the life of the loan, conventional multifamily and other commercial mortgage loans typically are not fully amortizing and are structured with shorter terms to maturity and balloon payments due on the final payment date. A balloon paymentWhen the principal balance of a loan does not fully amortize over the loan term, the final scheduled... is larger than the previous scheduled payments, as it includes all remaining unpaid loan principal as well as scheduled coupon interest.
Balloon payment strategies may be advantageous to borrowers, but the practice comes with risks as well. If clients qualify, lenders can recommend strategies to ensure that a balloon structure is the best option for both lenderThe person or party (such as a bank or corporate entity) that loans money on a commercial real estat... and borrower.
What Are Balloon Payments?
Balloon payments cover the unpaid balance of shorter-term mortgage loans and must be paid at the end of the loan’s term to retire the debt. As their name implies, these payments are often quite large. In a typical Freddie Mac Small Balance Loan (SBL) scenario, a borrower has a 10-year term with a 30-year amortization. After 10 years of payments, based on a 30-year amortization, the remaining unpaid balance will still be quite high.
Making a payment this large at the end of a short-term loan can be a burden for borrowers, but many address this issue by either refinancing or selling their real estate before the balloon payment is due.
What Are the Advantages?
One of the greatest advantages of balloon payments is that they allow commercial lenders to structure lower interest rates than would be otherwise feasible. Were such loans structured with fully amortizing terms, many wouldn’t generate sufficient proceeds to meet the borrower’s financing objective or would entail periodic payments that exceed the cash flow likely to be generated by the financed property and therefore be untenable.
Balloon mortgages are also typically easier to qualify for than fully amortizing loans, making them especially desirable for those who pass the underwriting requirements.
What Are the Risks?
The most obvious difficulty that could arise from a balloon loan is a shortfall of funds needed to retire the indebtedness on the final payment date. If the borrower is unable to refinance before the final payment becomes due, a default declaration and foreclosure could result.
Another issue that may arise is a decline in the market value of the collateral property. If upon maturity of the loan the value of the mortgaged property is less than estimated at the time of origination, the borrower may not be able to raise sufficient funds to retire the loan in full—either through asset sale or loan refinancing—exposing the borrower to possible default.
Qualifying for a Balloon Payment
There are several underwriting processes that may occur before a lender issues a balloon mortgage. For one, your lender may perform in-house exit tests to ensure that the borrower will have enough funds to avoid default on the loan’s final payment date.
These tests can help determine what the loan proceeds may be at the end of the loan term based on the assumed performance of the mortgaged property. The property’s loan-to-value ratio and debt-service coverage ratio underwriting parameters are often adjusted to take into consideration the property’s perceived risk of unexpected decreases in rent or increases in interest rates at the time of prospective refinance or sale at maturity.
If these tests are run and the lender determines that the property’s income may fail to support final loan repayment, the loan parameters can be adjusted to reduce the risk of default.
A World of Options
There are many factors at play when it comes to deciding which type of commercial real estate loan will best suit your needs. Learning the basics about balloon loans and payments will help you get a handle on the risks and rewards of this very common method of commercial real estate financing.