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Balloon mortgagesMost single family balloon mortgages originated today carry a fixed rate and a 30 year amortization schedule. They typically require a balloon repayment of the principal outstanding on the loan at the end of 5 or more commonly 7 years, although other balloon dates are possible. Balloon mortgage are attractive to borrowers because they offer mortgage rates significantly lower than generic 30 year mortgages in a steep yield curve environment. In turn the short final maturity of balloon mortgage pools offers investors substantial performance stability.
Nowadays many balloon mortgage contracts are actually hybrids that contain certain provisions allowing the borrower to take out a new mortgage from the current lender to finance the balloon repayment with minimal prequalification requirements. In order for the for the new loan to finance a balloon payment must not have been delinquent on payments at any time during the 12 preceding months, must still be using the property as a primary residence and must have incurred no new liens on the property.
Whether or not investors need to concern themselves with the refinancing option offered to the borrower in conjunction with issuance of the balloon loan depends primarily on what form the balloon investment takes. For instance, investors who own agency balloon mortgages can ignore the refinancing options offered to borrowers because the agency guarantees the ultimate balloon repayment to the investor in the case of borrower default. Investors in balloon mortgages with credit support provided in another manner, on the other hand, should carefully assess the sufficiency of that support to meet borrower, shortfalls at the balloon date, as the rating agencies do when assigning credit ratings to mortgage backed securities backed by pools of such loans.
It is possible, of course, that the nature of the refinancing option may influence borrower prepayment behavior before the balloon date, affecting both agency and non agency Balloon mortgage holdings. On this particular issue there are at least two schools of thought on the likely prepayment behavior of balloon borrowers. One theory suggests that conforming balloon borrowers have selected this type of mortgage because they believe that they are likely to move before the balloon date and thus pools backed by these mortgages will prepay faster than otherwise similar pools backed by generic fixed rate loans. A second theory suggests that the lower rate offered to balloon borrowers will tend to attract a wide range of borrowers, including marginal borrowers, so that the balloon pools would prepay similarly to or perhaps more slowly than generic 30 year pools. However, prepayment rates on balloon securities have in general been faster than those of other mortgage products with similar refinancing incentives, suggesting that balloon borrowers tend to be a self selected group with a shorter than average borrowing horizon.
III. Comparing A Balloon Mortgage to an Adjustable Rate Mortgage:
It is useful to compare five and seven year balloons with adjustable rate mortgages that have the same initial rate periods. Both offer a rate in the early years below that available on a fixed rate mortgage and both carry a risk of higher rates later on. But there are some important differences.
IV. Favoring the Balloon
V. Favouring the Adjustable Rate Mortgage
The risk of a substantial rate increase after five or seven years is greater on the balloon which must be refinanced at the prevailing market rate, whereas a rate increase on most five and seven year adjustable rate mortgages is limited by rate caps.
VI. Balloon Risk
Borrowers prefer balloon loans when the yield curve is positively sloped since they should be able to borrow at a lower rate. Investor appetite for short to intermediate term bonds also tends to favor balloon mortgages as collateral. However, balloon mortgages are considered more risky than fully amortizing commercial mortgages since there is more uncertainty about the repayment of principal at the balloon date. In the case of fully amortizing loans as long as the net income from the property is sufficient to pay the scheduled principal and interest, the lender will receive the promised payments. Since loans are originated with coverage ratios, the properties income has some room to decline from the origination date, and still be able to make the required payments. If the borrower defaults during the term of the loan, it is likely due to serious problems with the property which led to a precipitous drop in the properties income. On the other hand, most borrowers will have to make their balloon payment by refinancing their mortgage. The risk that a borrower may be unable to make his Balloon mortgage payment is known as balloon risk.
A borrowers ability to refinance will be a function of the loan to value at the balloon date, as well as coverage ratio at the date. There can be a variety of reasons why a borrower might be able to make principal and interest payments, but not be able to refinance. For example, income may have dropped and lenders may not feel the coverage ratio is sufficient for the amount to be borrowed. Alternatively, income may have stayed the same or even risen but interest rates may have increased even more, leading to an insufficient coverage ratio. Thus, the balloon date can represent a crisis point for a borrower.
It is not completely obvious how the risk changes as a function of the remaining time to the balloon date. There are several competing factors. On the one hand, for a given amortization schedule, the further away the balloon date, the lender would only agree to this if he expects that this will produce greater proceeds on a not present value versus foreclosure. Lenders realize that not only can foreclosure be time consuming and costly but in bankruptcy, the court could force the lender to accept a lower rate on the mortgage.
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