The Scary Truth About Balloon Loans
Balloon loan (noun) - type of loan that doesn't fully pay off the balance borrowed over its term, and requires a large principal payment at the end to repay the remaining balance due.
I want to make you aware of the hidden dark side, or two or three of this type of loan.
Full disclosure - I am not a fan of debt of any kind. I came to dislike debt through way too much experience being in debt. I have had almost every kind of debt there is: mortgages, car loans, student loans, personal loans, credit cards, and yes even business loans. Even now I'm not completely debt free.
But I want to take you through a closer look at the type of debt I dislike the most
Sorry bankers, but the hard truth is balloon loans only benefit the bank.
Banks have come under a tighter regulatory environment since the financial crisis of 2008, and are a lot less likely to make risker loans. However, I have witnessed banks making a lot of money from clients stuck in the revolving door of the short-term balloon loan years before the crisis.
Why would a bank offer a balloon loan in the first place?
A bank will typically offer a balloon loan in risker situations where there is no or limited financial history such as a new business without current cash flow. The thought being that at the end of the term, the business will have a financial track record to make projections about its future activities. With actual data about operations, the bank can then (hopefully and in a perfect world) offer traditional financing without a balloon payment for the remaining principle balance.
A big temptation to commit to a balloon loan (other than it is all the bank will offer) is the "benefit" of a lower payment. I mean you don't have reliable income yet so a lower payment sounds great, right? You are probably thinking three years is plenty of time to make your business profitable enough to pay the balloon, if not, "surely" I will qualify for traditional financing.
What I've seen happen in the real world:
The balloon loan is just renewed as another balloon loan (for a small fee of course!)
But, borrower beware the ugly truth...
Let's say you borrow $50,000 at 4.5% interest
Option 1 - 3/30 year balloon loan - Monthly payment $253 (your payment amount is based on a 30-year loan, but you only make 35 monthly payments leaving a large principle balance due on payment 36.)
Option 2 - Traditional 3-year loan - Monthly payment $1,487 (your payment is based on paying the entire balance in 36 payments.)
You pay almost 50% more interest to the bank
Total interest paid:
Option 1 Balloon loan = $6,588
Option 2 Traditional loan = $3,544
You will still owe 95% of what you borrowed
Balance owed after 3 years:
Option 1 Balloon loan = $47,721
Option 2 Traditional loan = $0
That lower payment doesn't look all that great three years later. Out of $8,867 in cash paid to the bank you only reduce what you owe by $2,279. That is a pitiful 5% of what you borrowed.
I have yet to see a small business with enough cash flow after just three years that can afford to payoff the balloon payment. This usually means another loan.
The bank has the advantage of getting a greater percentage of your payment as interest in the beginning of a loan. You don't get significant principle reduction until later in the loan. The cycle of renewing balloon loans allows the bank to keep the advantage.
But wait! It gets worse!
I have never reviewed a balloon loan agreement that wasn't over-collateralized
(I'm not saying every bank over-collateralizes every balloon loan, but again, I haven't witnessed one.)
This is the collateral securing a $55,000 new business loan from an actual loan agreement (any identifying information has been changed):
999 Main St Anytown, GA 30303 DSD 04/15/16
08 Chevrolet Silverado VIN# 9ABCD12345EF67890
91 Ford Explorer VIN# 9A1BC23D4EF567890
All equipment, fixtures, accounts receivable, accessories, inventory, instruments, documents, chattel paper, general intangibles, contract rights and cash used or to be used in business know as Company X now owned or hereafter acquired, and all products and proceeds there from, where ever located, but currently located at 999 Main St Anytown, GA 30303 and any other locations Company X operates now or in the future.
The bank certainly seems to have their choice of options if the loan isn't paid as agreed. (With this much collateral why not go ahead and offer a traditionally amortized loan?)
Why does collateral matter so much?
You are putting it all on the line.
If the business fails, you could lose everything it owns plus your major personal assets. Technically, you could end up homeless with no transportation.
Starting a new business is hard work. You have to be committed to building your business. You have to dedicate your efforts into building you business. You have to sacrifice your leisure time to build your business.
After three years of hard work. After three years of commitment, dedication and sacrifice do you want to still owe the bank virtually every dollar you borrowed or celebrate not owning the bank a dime?
So what other options are there if I need cash to start my business?
There are many benefits to bootstrapping a new venture. The obvious one is not paying the bank $6,588 in interest. But a not-so-obvious benefit is feeling like an entrepreneur. There is incredible motivation in knowing your resourcefulness and creativity built your business. You can never get that feeling just signing a piece of paper.
So let's get to bootstrapping!
Be very conservative with what you actually need to spend money on. Don't include things you want on the list of things you need. Be very honest with yourself about what is essential.
look for less expensive options. We all love shiny new stuff, but usually a used one will serve just as well. Used equipment can be a tremendous savings. Better yet - can you rent the equipment when you need it? That way you aren't paying money for something just sitting around unused.
Sell items you own. Virtually everyone knows the story of John Schantter selling his car to start a pizza parlor. That was a big decision in 1983, but in hind-sight I be we all would gladly make that choice.
Think about it. Will it be easier to sell that box of comic books or unused china now or give the bank $6,588 of your hard earned money later?
Reduce your current expenses. We all spend money on unnecessary stuff. We also overspend on necessary items. Reevaluate your current budget and you might be shocked by how much money you can keep.
Start small and grow slowly. My first job after college was working for a homebuilder developing three subdivisions and selling about one hundred and fifty homes a year. The first year in business he built and sold one house.
You will learn so much about running a business in your start-up years. Go slow and build your business on a strong foundation (pun intended.)
Delay launching. Yeah! I know, this is a tough one. You are excited and ready to get started. But believe me cash flow problems will zap your excitement quickly! Give yourself time to implement these suggestions. Our venture capital business world likes to "fail fast" and move on to the next big idea. For every Uber there are many more Quickys, Rdios, Aereos and, yes, Pets.coms.
Slow and steady business fundamentals just aren't as sexy, but they still work! Making the hard choices now pays multiple dividends later. I'm sure $6,588 can buy you a lot of delayed gratification.
For even more tips, download my free guide, "7 Ways to Waste Time & Money in Business (and How to Stop It!).