This guest post is courtesy of AgSouth Farm Credit.
Which is better: A 5.3% on a 20-year Term with a 3-year Balloon or 6.2% fixed rate on a 20-year Term?
When shopping rates, be sure you are comparing apples-to-apples. Although you might initially consider only the interest rate, what does “Fixed Rate“ or “Balloon“ really mean? Knowing the term is just as important as knowing the rate attached to it.
For the past ten years, borrowers have appreciated historically low interest rates for both short-term and long-term debt. However, recent improvements in the economy are also bringing rising interest rates.
WHY FIXED INTEREST RATES?
First and foremost, choosing any option should be based on your financial position and your plan for the type of debt that you are considering.
In today’s rising rate environment, a Fixed Rate can help you manage risk. For the near term, longer term Fixed Rates have little room to decrease; however, we are seeing the potential for some additional increase.
A Fixed Rate loan means that your loan payment is set for the term of the loan. The interest rate on your loan cannot increase. When a lender is quoting a rate to a borrower, one of the factors they consider is risk. One component of risk that plays out with Fixed Rates relates to the Term (length of time to pay the loan). Generally, a 20-year Fixed Rate has more risk because there is more time for things to go wrong. Thus, you would expect to pay a higher rate for a 20-year loan than you would for a 5-year loan.
The question to ask yourself is, “What term do I need to generate a reasonable payment based on my income and cash flow?”
FIXED INTEREST RATE VS BALLOON
So, what is the difference in a full-term Fixed Rate vs. Balloon feature? Does it matter?
A Balloon loan is often referred to as “A 20-year Term with a 3-year Balloon” (or similar Terms). Simply put, this loan is based on a payment over 20 years, but the rate is good for only 3 years. After 3 years, both the interest rate and monthly payment are subject to increase. On the other hand, a 20-year Fixed Rate has a 20-year guarantee with no payment change.
Now, you probably concluded that the 20-year Fixed Rate will likely be higher than the 3-year Balloon. And you would be correct. But there is more to the story.
On a Balloon feature, the loan will mature in 3 years and the principal balance will become due. Assuming your financial condition remains satisfactory, a lender may refinance the remaining principal for you. The result is a new loan that will be priced according the current interest rate environment.
The risk to you? No one can anticipate what rates will be 3 years down the road. With a 20-year Fixed Rate, that risk is removed from the equation because you know that your rate will not change. So yes, when you take out the initial loan, a 20-year Fixed Rate – in most cases – will be higher than a Balloon. So the question to ask is “How much more is the rate? Does it make sense to fix a rate based on where I think rates are headed?” Whatever the rate is after 3 years is what you will have to pay for the remaining 17 years of your loan when that Balloon payment turns into a Fixed Rate payment.
Next you might ask, “What if rates are lower in 3 years than they are now?” Here at AgSouth Farm Credit, we monitor the decreasing rate environment and will actually reach out to our customers and let them know that rates have fallen and offer them a chance to renew the loan at a lower rate. Why would we do that? Because we want what’s best for our customers.
BALLOONS CAN BE A GOOD CHOICE
So why would you want a Balloon loan? There are situations where Balloon terms are beneficial, especially in certain cash flow situations. One example is if you are planning to manage the timber on your land purchase. If your management plan includes harvesting at certain intervals, you may want to establish a Balloon to coincide with your harvest plan. A Balloon will allow you the ability to apply timber proceeds to the loan principal and then refinance the outstanding balance over the term of the loan. Doing this can either reduce your loan payments or decrease the loan term and keep your payment the same. The benefit is the ability to pay off your debt earlier than anticipated.
In today’s rising interest rate environment, consider your options carefully. Fixed Rates can help manage risk for longer term acquisitions, such as real estate purchases. Balloon terms may be beneficial if you anticipate cash influx at the time the Balloon period is over.
In the end, the rate type and term of the loan you choose should be based upon your financial situation and investment goals.
If you are interested in talking more about how best to structure the loan on your next land purchase, please visit AgSouthFC.com to find a branch location near you.