One of the interesting features of real estate investing is the variety of financing options available. Indeed, one such option is the partially amortized loan. Certainly, this type of loan is popular among commercial real estate investors, as it offers some compelling benefits. In this article, we’ll review the definition of a partially amortized loan, contrasting it with the fully amortized loan definition. Furthermore, we’ll consider the pros and cons of a partially amortized loan. We’ll also discuss whether it’s the right type of loan for you. Finally, we’ll finish with an example calculation and frequently asked questions.
What Is a Partially Amortized Loan (PAL)?
The definition of a partially amortized loan is straightforward. Uniquely, the PAL amortizes only partially during the loan term before the borrower makes a balloon payment. In other words, the loan term is shorter than the amortization period. Truly, a PAL usually charges a fixed interest rate for a period of seven to nine years. Usually, the amortization period is 30 years, often more than 20 years longer than the term. Eventually, when the term ends, the borrower pays off the remaining balance with a single balloon payment.
For amortizing loans, the loan payments are the same each month. Overall, what varies is the split between repayment of principal and payment of interest. To begin with, most of each payment goes toward interest. However, as time goes by, the pendulum swings toward principal, and by the end, the payment is virtually all-principal. Certainly, this reflects the lender’s determination to collect its profit up front.
Naturally, if the loan amortization period is 30 years and the loan term is 9 years, a mismatch exists. However, the borrower solves the mismatch with the balloon payment at the end of the term. Importantly, one form of partial amortization loan is an interest-only loan. Indeed, the borrower makes only interest payments during the amortization period. Then, the borrower pays off the loan with a huge balloon payment, equal to the original loan balance.
Video: What is Loan Amortization?
Partially Amortized Loan vs Fully Amortized Loan
The difference between a PAL and a fully amortized loan is the term. In fact, for a fully amortized loan, the term and amortization periods are identical. Conversely, a partially amortized loan has a term that is shorter than the amortization period. Notably, that’s why the borrower must make a balloon payment at term’s end for a PAL. Clearly, most of the amortization payments apply to interest, whereas the balloon payment represents mostly principal.
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Benefits of a Partially Amortized Loan
A partially amortized loan provides several benefits:
- Reduced Duration Risk: The lender reduces its duration risk, that is, the risk that interest rates will rise. Obviously, this hurts the provider of the fixed-rate loan, since it ties up money in a now-underperforming loan. Therefore, by making the term shorter, the lender of a partially amortized loan can reclaim its money sooner. Moreover, it can sooner relend the money at the new, higher interest rate. Of course, this cuts the lender’s potential loss compared to a fully amortized loan that runs decades longer.
- Higher Purchasing Power: Usually, borrowers can get a larger loan if it is a partially amortized loan. Obviously, that’s because the lender has reduced its duration risk and can therefore demand a slightly smaller down payment. Also, it can charge a lower interest rate. Indeed, these benefits provide the borrower more purchasing power and a better return on investment.
- Faster Sale: A partially amortized loan supports a strategy to sell the property at the end of the loan term. As a result, the seller can use the sale proceeds to fund the balloon payment.
Disadvantages of a Partially Amortized Loan
You should understand the disadvantages of a partially amortized loan:
- Default Risk: A partially amortized loan only works if the borrower can make the balloon payment at the end of the term. Thus, any failure to come up with the large balloon amount will result in a default. However, the borrower can refinance or sell the property for enough money to fund the balloon payment. Any leftover sale proceeds go toward a possible capital gain and an overall profit.
- Refinancing Risk: If the owner wants to keep the property rather than sell it, it will seek refinancing at term’s end. However, under certain circumstances, refinancing might be unavailable or unattractive. In the extreme, this might lead to bankruptcy.
Is a Partially Amortized Loan Right for Me?
A partially amortized loan can make sense under several scenarios:
- Exit Strategy: You plan to sell the property before the balloon payment comes due. You get the benefits of a partially amortized loan without worrying about the balloon payment.
- Tight Cash Flows: Your initial cash flows from the property will be low. For example, you might have to refurbish a rental property before you can stabilize it. The lower payments from a partially amortized loan or interest-only loan reduces your cash requirements.
- Marginal Credit: You might not qualify for a fully amortized loan. However, you just might qualify for a partially amortized loan due to smaller payments.
How to Calculate a Partially Amortized Loan
The Omni Calculator for partially amortized loans is a representative PAL calculator. You use a partially amortized loan calculator by entering the required data. This includes the full loan amount, the annual interest rate, the amortization period and the term. The result returned will include the monthly payment, the total monthly payments and the balloon amount.
Example PAL Calculation
Imagine you want to purchase a $12 million property with a $10 million PAL. You can get a loan with a 30-year amortization schedule and a 7-year term. The lender charges you 8.5% fixed interest. According to the Omni Calculator, your monthly payments will be $76,891.35, for a total of $6,458,873.26 after 7 years. The balloon payment will be $9,307,904.75, giving a grand total of $15,766,778.01. Note that this exceeds the original mortgage amount by more than 50%.
At the end of the 7-year term, you sell the property for $14 million. After paying the balloon amount, your cash proceeds are $14 million minus $9,307,904.75 = $4,692,095.25. You originally put down only $2 million, yet your overall profit is also $2 million. That is 100% return after 7 years.
Frequently Asked Questions: Partially Amortized Loans
What is a straight loan?
A straight loan is an interest-only loan. You make interest payments each month, and then pay off the entire balance at the end of the term. This is a good strategy when you need to conserve cash.
Why do banks amortize loans?
Banks want to grab their interest income as quickly as possible. Amortizing a loan allows banks to front-load the interest payments. This way, the bank earns its interest income first before recouping its principal.
How do balloon payments relate to amortized loans?
Borrowers make balloon payments when the amortization period is longer than the loan term. A balloon mortgage is a partially amortized loan or an interest-only loan. When the term ends, the borrower can sell the property, refinance it, or simply pay the balance in full.
What is negative amortization?
A negative amortization loan occurs when you owe more at the end of term than you initially owed at the beginning of the loan term. You can obtain a balloon mortgage with negative amortization, meaning your monthly payments are less than the interest expense. These loans are risky and have a negative stigma.