This week we’re going to take a look at a note that has a balloon on it!
A lot of home loans out there amortize fully over 15, 20, or 30 years. That means that after that length of time, they’re all paid off and the borrower doesn’t owe anything more.
There are others, however, that amortize over the same schedule, but they’re due in full after a certain period of time, say 5 years.
Over the last three weeks, we took a look at buying a fully amortizing note and doing various things with it to get a good return on my investment. This week, we’ll do some analysis of a note with a balloon instead… and how much we’d be willing to purchase that balloon for.
I’m looking at a loan for $120,000, at a 4.75% rate, amortizing over 30 years but due in 5 years.
a) What’s the payment on this loan?
b) How big will the balloon be if no additional principal payments are made during the five years?
c) If I wanted to get a 15% return on my investment, how much would I be willing to pay today for that balloon in 5 years?
d) How about if I wanted to get a 20% return?
a) N is 360 (it amortizes over a 30-year term), I/YR is 4.75, PV is $120,000, and FV is $0. This last bit is important, because although the loan has a balloon, when we calculate the payment, that’s based upon a fully-amortizing loan – when it’s due is generally not important to the payment. Plugging in those numbers and solving for PMT, I find that the payment on the loan is -$625.98.
b) N is 60 (the balloon happens in 5 years, or 60 months), I/YR is still 4.75%, PV is still $120,000, and PMT is -$625.98. Solving for FV, I find that after 5 years, the amount still owed on the loan will be -$109,797.88. That’s the amount of the balloon. Interesting that after 1/6th of the lifetime of the 30 years, it’s only 1/12th paid off, huh? It’s almost like the banks make this kind of loan on purpose…
c) N is 60 (that’s the length of time between when I pay for the balloon and when I get the payment), I/YR is 15 (my desired yield), PMT is $0 (I’m neither getting nor paying any money between now and five years from now), and FV is $109,797.88 (the amount of money I’m buying). Solving for PV, I find that I should pay -$52,106.52 for the balloon.
d) All of the numbers in this one are the same as in part c) with the exception of I/YR, which is 20. Solving for PV, I find that I should pay -$40,726.67 for the balloon.
Buying balloons can be a riskier proposition than buying payment streams, because balloons don’t always get paid off. That’s why I want to pay much less than the face value of the balloon ($41,000 – $52,000 for a $110,000 balloon). There are a lot of options for the owner of a balloon to work with the person that owes it, and there’s a chance that a refinance or sale will happen (thus paying the balloon I’m owed) or that the borrower will not perform and grant me a deed to the collateral property in lieu of paying me the balloon. If I were able to pick up a $150,000 house in 5 years for $41,000 today, I might be pretty satisfied with that investment.
Pay attention to this scenario, though, as I’ll be coming back to it in future weeks when we talk about buying future payment streams for money today.
Thanks for sticking with me to the end! If you have any questions or comments, please let me know in the comments below!