Are Prepayments on a Balloon Loan Wise?
May 24, 1999
"I recently purchased a condominium financed by the seller at 5.5% interest over 34 years, with a balloon due in 10 years. Is it wise for me to make extra principal payments so that the balloon payment will be smaller, or should I invest my extra income in other ways?"
Your question has no right or wrong answer. It depends on your tolerance for risk.
You want to be in a position to refinance the loan balance in 10 years at advantageous terms. While there is no telling what interest rates will be like at that time, you should plan to have sufficient equity in the property that you are not thrust into the high-risk segment of the market. (Judging from the terms of your deal with the seller, my guess is that you have little equity in the property today.) This means that your loan at that time must be no more than 95% of property value. An 80% loan would be even better because it would allow you to avoid paying for mortgage insurance.
Lets assume that your goal is to refinance no more than 80% of your current balance. If you have no equity today, this goal implies that you either repay 20% of the balance, or accumulate the same amount in an investment account.
When you make an extra payment to reduce the balance on a 5.5% loan, you earn a return on your investment of 5.5%. That's better than you can earn in a bank or money market account, but not as good as you can do in the stock market. A stock market investment, however, carries the risk of a decline in value in the short term.
If your balloon payment was due in 3 years I would advise investing in loan prepayments because the return is certain and stock market returns are not. Over 10 years, however, the chances of not earning more than 5.5% by investing in a diversified portfolio of stocks is small. That's what I would do. But an extremely risk averse investor might opt for the prepayment route.
A word of warning in the event that you do select the safer option of prepaying the loan. If you add $100 to your monthly payment, the interest due the following month should be calculated on a balance from which that $100 has been deducted. This happens automatically on a loan from an institutional lender, but a seller might be using a back-of-the-envelope accounting system that does not properly credit your prepayment. You need to make sure that doesn't happen.
"I recently purchased a condominium financed by the seller at 5.5% interest over 34 years, with a balloon due in 10 years. Is it wise for me to make extra principal payments so that the balloon payment will be smaller, or should I invest my extra income in other ways?"
Your question has no right or wrong answer. It depends on your tolerance for risk.
You want to be in a position to refinance the loan balance in 10 years at advantageous terms. While there is no telling what interest rates will be like at that time, you should plan to have sufficient equity in the property that you are not thrust into the high-risk segment of the market. (Judging from the terms of your deal with the seller, my guess is that you have little equity in the property today.) This means that your loan at that time must be no more than 95% of property value. An 80% loan would be even better because it would allow you to avoid paying for mortgage insurance.
Lets assume that your goal is to refinance no more than 80% of your current balance. If you have no equity today, this goal implies that you either repay 20% of the balance, or accumulate the same amount in an investment account.
When you make an extra payment to reduce the balance on a 5.5% loan, you earn a return on your investment of 5.5%. That's better than you can earn in a bank or money market account, but not as good as you can do in the stock market. A stock market investment, however, carries the risk of a decline in value in the short term.
If your balloon payment was due in 3 years I would advise investing in loan prepayments because the return is certain and stock market returns are not. Over 10 years, however, the chances of not earning more than 5.5% by investing in a diversified portfolio of stocks is small. That's what I would do. But an extremely risk averse investor might opt for the prepayment route.
A word of warning in the event that you do select the safer option of prepaying the loan. If you add $100 to your monthly payment, the interest due the following month should be calculated on a balance from which that $100 has been deducted. This happens automatically on a loan from an institutional lender, but a seller might be using a back-of-the-envelope accounting system that does not properly credit your prepayment. You need to make sure that doesn't happen.