Note buyers need to know about the “balloon battering” rule in Chapter 13 bankruptcy. If your payor files Chapter 13, a final balloon payment on a note secured by the payor’s home can be delayed for up to five extra years.
What the balloon battering rule allows
If your payor files Chapter 13 bankruptcy, your note is secured by the payor’s principal residence and the payor owes you a cash-out balloon, you might have to wait and wait and wait for your money.
Bankruptcy Code Section 1322(c)(2) took effect in October 1994. It lets your payor subject your right to a balloon payment to rough treatment and heavy blows: the balloon can be stretched out for up to five years. Before that date, balloons were normally unalterable.
For example, if you buy a note with a payment-in-full provision due in 3 years, your payor’s Chapter 13 plan could stretch that balloon to 8 years.
What the code says
Part of Section 1322(c)(2) reads:
“…in a case in which the last payment on the original payment schedule for a claim secured only by a security interest in real property that is the debtor’s residence is due before the date on which the final payment under the plan is due, the plan may provide for the payment of the claim as modified…”
In this language, the “last payment” is your balloon and the “debtor” is your payor. Section 1322(d) then sets the outer limit:
“The plan may not provide for payments over a period that is longer than three years, unless the court, for cause, approves a longer period, but the court may not approve a period that is longer than five years.”
How a stretched balloon hurts you
- Your yield can drop substantially, because the time value of your money may be figured over 8 years instead of 3.
- Your cash could be tied up for an extra 5 years, which may upset your plans for liquidity.
- Partials get messy. If you bought a partial, part of the note, and your seller is expecting money from the balloon proceeds, you may have a serious problem with your note seller when the balloon isn’t paid on time.
Ways to protect yourself
You have a few choices with notes like these:
- Offer less money, keeping in mind that your yield may be diminished.
- Shy away from this type of note, especially if you think you’ll need the cash when the balloon comes due.
- If you are a risk-taker, take your chances, disregard the possibility of balloon battering and hope the payor never files Chapter 13.
If you are involved in a partial where the seller is expecting cash from the balloon, your documents should contain full disclosure of this risk.
You are advised to consult a bankruptcy attorney before buying notes with balloons that are secured by the payor’s personal residence.
