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In our last issue we discussed the problems with balloon payments both from a lender’s or note seller’s perspective (complying with the Dodd-Frank legislation) and from a note buyer’s perspective (valuing a note that includes a balloon payment). In this issue I would like to introduce you the mathematics of step payments. If you are not familiar with the financial calculator, watch this video to see it in action.
Let’s utilize the following loan example to do our calculations and compare the Balloon and the Step Payment plan:
Here is how this scenario plays out:
Now let’s determine the balloon remaining after 60 months of payments.
Pretty straightforward calculations using a financial calculator. The monthly payment would be $990.58. The balloon payment in 60 months would be $128,344.31.
What is this loan worth to a note investor who may be willing to buy it? Assume the investor note buyer is looking for a 10% yield: The stream of 60 payments would bring $31,384.19.
What is the balloon worth? Here is where the problems begin.
A prudent note buyer will have two concerns. First, if the borrower could not qualify for a conventional loan at the time of the sale why should the note buyer believe the borrower can qualify to refinance the balloon in 6o months. This uncertainty creates higher risk which translates into a lower price for the note. The second concern is the value of the property at the time the balloon is due. How positive can the note buyer be that the property will appraise at a value high enough to cover the balloon payment. Most often when we are presented with a note to purchase that has a balloon, we offer to purchase the stream of payments and have the note seller keep the balloon.
If the prudent note buyer decided to buy the entire note, i.e. the stream of payments plus the balloon how would that buyer determine the price to pay.
First, the purchase price on the stream of payments would be determined. Remember that was $31,384.19. That remains the same. Next we must determine the price to pay for the balloon or that lump sum that is due in the future or how much would I pay now to receive $128,344.19 in sixty months if I wanted a 10% yield.
So we would had the two sums together $31,384.19 plus $ 78,006.21 and would pay a total of $109,390.40. Unfortunately because of the higher risk factor inherent in the balloon the note buyer may want a higher yield spread on the balloon portion of the purchase seeking a larger discount.
Doing the calculations on the step payment is a bigger challenge. In the next issue we will use the software, T Value to calculate the payment schedule on the step payment and then determine how to value what to pay for that note.