Destined to Reign

THE IDEA

The monthly installment of a conventional home loan is computed based on reducing balance basis, whereby each of the payment will consist of interest and principal component. The interest portion will make up majority of piece in a repayment during the beginning of loan tenure and it will diminish when the time move on and a bigger portion of payment will turn to knock off the principal. This is the concept which we often known as amortization.

While, the idea of 3P by a local bank, features the concept of balloon payment (or known as bullet payment). The concept itself is not new to the market, and being attempted by a couple of other banks with effort to advocate borrowers. Historically, balloon payment mortgages were first introduced in 1934 in U.S. along with the loan programs by the Federal Housing Administration (FHA) in boosting the ownership of properties. In those day, balloon payment loans were usually meant to be short termed, ranging from 3 to 5 years and people will convert or refinance it into a term loan structure subsequently. The popularity of balloon payment mortgages gained during 1980s and peaked at 1990s when interest rate crept up to higher levels. The balloon payment option made the monthly repayment lower and more affordable in short term.

FUNDAMENTAL MECHANISM

The monthly installment of a balloon payment mortgage is being segmented into 2 portions :-

(i) a portion of the total loan has its monthly installment calculated based on a reducing principal, while;
(ii) the other portion has its monthly installment calculated based on definite and stagnant principal

By the end of the tenure, portion (i) will be reduced to zero balance while portion (ii) will remain the same balance as the beginning of tenure and has to be settled in a lump sum payment.

EXAMPLE ILLUSTRATION

Consider Mr A plans to take up a home loan of RM500K, tenure 30 yrs, interest is priced at BLR -2.3% (BLR = 6.3%, effective interest rate at 4%).

1. Conventional Home Loan

Monthly Installment = RM2,387.08

The home loan has its interest calculated based on the previous day outstanding balance. When the outstanding being reduced, the interest due will be reduced in proportion as well.

1st Month; Out of the RM2,387 monthly installment, RM1,666.67 is the interest due based on the outstanding amount of RM500K while the remaining RM720.41 will be used to knock-off the principal.

Note; RM500K X 4% X 30/360 Days = RM1,666.67

2. Balloon Payment Mortgage

Consider Mr A decided he is going to settle 50% of his total loan in a lump sum by the end of the tenure, thus loan amount will be :-

Portion (i) = RM250K
Portion (ii) = RM250K
Total = RM500K

The monthly repayment calculated based on balloon payment is RM2,026.87, which is RM360.21 lower than standard scheduled monthly installment. How does it work? Portion (i) will have its monthly installment calculated based on amortization method :-

Thus, portion (i) will have a monthly installment of RM1,193.54 only.

1st Month; Monthly installment consists of RM833.33 interest due and RM360.21 to knock-off the principal.

Note; RM250K X 4% X 30/360 Days = RM833.33

While portion (ii) will have a definite non-reducing principal loan of RM250K. Each of the months, only interest will be served. Interest due for each month :-

RM250K X 4% X 30/360 Days = RM833.33

Thus your total monthly payment is RM1,193.54 + RM833.33 = RM2,026.87

It is clear that every payment will only serve interest incurred in portions (i) & (ii) and principal of portion (i) only. The principal in portion(ii) will NOT be served.

Outcome :-

1. Month repayment of a balloon payment mortgage will be lower than conventional ones. Based on rule of thumb, repayment will be lower by :-

15% - if portion (ii) is 50% of total loan amount
12% - if portion (ii) is 40% of total loan amount
09% - if portion (ii) is 30% of total loan amount
06% - if portion (ii) is 20% of total loan amount
03% - if portion (ii) is 10% of total loan amount

2. Interest cost will be higher with balloon payment mortgage, (if no refinancing and no additional payment). Based on rule of thumb, total interest cost will be higher by :-

30% - if portion (ii) is 50% of total loan amount
24% - if portion (ii) is 40% of total loan amount
18% - if portion (ii) is 30% of total loan amount
12% - if portion (ii) is 20% of total loan amount
06% - if portion (ii) is 10% of total loan amount

Usage :-

Balloon payment is used to be a short term arrangement as it lowers the monthly installment at the cost of increasing interest cost throughout the tenure. Normally, investors and those homebuyers who look for better cashflow position in short term will look for this option.

source:propertywtf