Land Loan Interest Rate Shopping? Compare Fixed Rate and Balloon
Land Loan Interest Rate Shopping? Compare Fixed Rate and Balloon
When shopping rates for land loans, be sure you are comparing apples to apples. Knowing the term is just important as knowing the rate. 8% of a 20 year term with a 3 year balloon is different than a 8.5% fixed rate on a 20 year term. Which is better?
First, it’s important to understand your current financial position and long term plan for the type of debt as well as the property you are considering. Second, keeping an eye on the interest rate environment may also sway your decision.
What is a Fixed Rate?
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 the lender considers is their risk. One component of risk that plays out with fixed rates relates to the “term” or the length of time to pay the loan. Generally, a 20 year fixed rate has more risk to the lender because there is more time for things to go wrong with the borrower. Because of this, you would expect to pay a higher rate for a 20 year loan than you would for a 5 year loan.
How Do Fixed Rate and Balloons Compare?
So, what is the difference in a full-term fixed rate compared to a balloon? Does it matter?
Questions you should ask yourself are “What are my plans for property long term” and "What term do I need in order to have a reasonable payment based on my income and cash flow?"
A balloon loan if often referred to as a “# of year term with a # of year balloon.” (Example: 20 year term with a 3 year balloon.) Simply put, this loan is based on a payment over X amount of years (usually 15 or 20 for land loans) but the rate is only good X amount of years (usually 3 or 5 but can vary by lender). After the number of years on the balloon concludes, both the interest rate and monthly payment are subject to increase.
On the other hand, if you were to get a 20 year fixed rate for example, you would have the same rate and monthly payment guaranteed for 20 years.
The Downside of Balloon Rates
As we stated earlier, a 20 year fixed rate will likely be higher than a 3 year balloon. But there is more to the story. On the balloon note, the loan will mature in 3 years in this example 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 to the current interest rate environment. No one can anticipate what rates will be 3 or 5 years down the road. With a fixed rate, that risk for you is removed from the equation because you know that your rate will not change.
You should ask yourself questions like “How much more is a fixed rate compared to a balloon rate currently?” and “Does it make sense to fix a rate based on where I think rates are headed or my long term plans for the land?”
If you are buying land to build your dream home, for recreational purposes like hunting, or for certain full-time farming operations, fixed rate land loans typically tend to be better for the borrower’s cash flow in the long term.
What if Interest Rates Fall During Your Fixed Rate Land Loan?
At AgSouth, we want what’s best for our customers and rural America. Our loan officers 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.
When Balloons Can be a Good Choice
There are situations where balloon terms are beneficial, especially in certain cash flow situations and rate environments.
If you are buying land to build your dream home, but plan on sitting on the land for a few years before you start construction, depending on the rate environment and your cash flow you may feel more comfortable getting a balloon rate to save on payments in the short term. It’s important to talk to a loan officer about your long term plans for your property so they can recommend next step loan products like our construction to permanent program when you’re ready to build.
If you are buying recreational land with timber and your timber 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.