When a banker says “term,” they mean a timeframe. On commercial real estate loans there are usually three of them, call them the “repricing term,” “balloon term” and “amortization term.” You can remember them like Volleyball: bump, set, spike.
- Bump (repricing): how often the interest rate would change.
- Set (amortization): how long before the loan would be paid in full.
- Spike (balloon): how long before the loan would be due in full.
The repricing term: that’s just how often the interest rate would adjust.
A “float rate” would adjust every time its index changes.
A fixed rate loan is the opposite extreme. There is no repricing term. The interest rate stays constant for the whole life of the loan.
Variable rates come in-between. A float rate can change daily; a variable can change once per month, per quarter, per year or at longer intervals specified by the loan contract.
Balloon term - that’s when the principal, or whatever’s left of the principal, must be paid. An example will make it simpler to explain.
So say you have a ten year balloon term on a loan. You make payments of principal and interest each month for ten years, with each payment reducing the balance owed. At the end of year 10, however, all unpaid balance is due, and it could be a big number.
Sure, but I don’t get it. I have a 10 year balloon, why isn’t my loan paid off by year 10? Because the amortization term might be longer than the balloon term, that’s why.
The amortization term is how long it would take you to pay all the way down to zero, at the scheduled payment you are making today.
So now we have a 10 year balloon with a 25 year amortization term. Without a balloon, the principal would be whittled down to zero after 25 years. Now, whatever’s left at the end of year 10, must be paid.
On commercial real estate loans, all three of these terms can be different lengths. For example, two 5-year repricing terms, a 10-year balloon and a 25-year amortization. That would be “25-year am.” in lender-lingo.
Imagine the balances on a chart: This loan’s actual balance is shown with the solid line. The dotted line shows where the balance would be if no balloon were due at year 10. The arrows represent the two 5-year repricing periods. Just before year 10, the balance on the loan is still over $800,000; then all of it is due and the solid line plummets to zero.
Yes, the 10th year of 25 is 40% of the time, but less than 20% of the money is gone. Amortizing loans pay a lower percentage of principal at first, a higher percentage later. If there were no 10-year balloon, the balance would be on the dotted line. It comes down only a little in the early years, and more quickly as year 25 gets closer. Loan payments are set based on the idea that the year-25 payment will zero out the loan. That’s assuming the rate does not change and there is no balloon payment to make.
A Lower Rate
The longer your repricing term, the higher the rate, generally speaking. The reason: Treasury rates generally move up in tandem with term. (Think: risk, uncertainty, inflation, etc.) Plus, a bank’s own funding costs are higher for longer terms (cost is passed along.) So some borrowers choose a 3- or 5-year repricing; it is only sensible to lower the rate. The shorter your term, the quicker your rate resets, up or down.
Notice our balloon term is shorter than the amortization term. No, it’s not a typographical error. Just as shorter repricing gets you a lower rate, a shorter balloon also gets a lower rate. The bank gets its cash back sooner. So the shorter the balloon term, the less risk it represents to the lender, and the lender passes the savings to the borrower.
A second reason for the balloon is servicing. The larger the loan, the less it costs a bank to service. Towards the end of amortization the balances get small. If a bank has to service a lot of small loans, it would have to charge more.
Wait, I’m still confused. Why do you have such a long amortization term? Because you want smaller payments. This loan, for example, is for $1 million at 7% for 25 years. The payment is $7,067/month. The same loan for 10 years is $11,611, or $4,544 more, an increase of 64%. Businesses usually borrow because cash is tight. And that’s why, for the cash-strapped borrower, a longer amortization period is usually the easier one to carry.
Two Common Ways to Handle a Balloon Payment
If the amortization term is longer than the balloon term, however, you better do a little calculation at closing. There will be a balloon at the end of that term, and you will not want to borrow unless you know how you’ll pay it. There are two common ways to handle a balloon payment.
- One, come up with the cash, if you have it.
- And two, if you don’t have it, replace the loan with a new one. It could be bigger than the old if the value of the property has gone up, of course.
Match Your Terms to Your Cash Flows
Moral of the story: match your terms to your cash flows. An equipment or real estate owner who uses plastic or a line may have cash issues, a liquidity problem. The underlying reason for it is that a property, machine, business will pay you back over time, but a card or credit wants its money back faster. Payments outrun the cash the asset will generate.
Generally speaking, the rule of thumb: Short-term money for short-term needs (like buying inventory); long-term money for long-term needs (like property or equipment).
Inventory needs are “current” needs. And not all the business’ current needs are a few days or weeks. Working capital = current assets - current liabilities. Accounts receivable represent a portion of sales. They grow with sales, shrink only if sales shrink: permanent working capital. So even “current assets” can create a long-term need. If your sales keep growing so do receivables. They go up and stay up, so a credit line won’t do. That growth should be funded with long-term debt or equity.
Pick your combo: choose it to match your cash flows and make the biggest profit.
- Repricing: If rates are very low, consider longer term or even a fixed. The reason: although rates might go lower, they may not. You eliminate risk of rising rates with a fixed rate. Shorter repricing terms can be wiser when: a) if rates might fall and b) if your cash flows move with rates. Shorter means lower rate in most cases.
- Balloon: the longer the balloon, the more time you have to save or refinance. Shorter might lower the rate.
- Amortization: Shorter means larger payments but generally a lower rate; longer means smaller monthly payments.
About Delancey Street
Delancey Street is a premier, and award winning, business debt settlement company that helps business owners nationwide. Our goal is simple: help you escape debt in a safe and legal manner. Based out of New York, we can help in 49 of 50 states. We tell you how it is; because your business and future is on the line.
