What is a balloon payment?
A balloon payment is a larger-than-usual one-time payment at the end of the loan term. If you have a mortgage with a balloon payment, your payments may be lower in the years before the balloon payment comes due, but you could owe a big amount at the end of the loan.
Balloon payment can be a part of both fixed as well flexible interest rate structures. By attaching a balloon payment to a loan, the borrower is able to cut down on the interest payment that is being made on a monthly basis by the borrower. This can only be possible because the entire loan is not amortized.
The good part about balloon payments is that they have lower initial payments. They are ideal for companies or borrowers who might be facing a cash crunch in the short term but expect the liquidity to improve in the future.
If a loan has a balloon payment, then the borrower will be able to save on the interest cost of the interest outflow every month. For example, a person ABC takes a loan for 10 years. In this type of loan with no balloon payment, his/her entire loan will be amortized in small monthly payments till the time his/her entire loan is paid.
If there is balloon payment involved then, usually, the entire principal payment is paid in lump sum towards the end of the term. The sum total payment which is paid towards the end of the term is called the balloon payment.
Customers find it convenient to make a balloon payment, especially those who do seasonal jobs and expect strong cash flows before the loan term expires. However, if they are unable to make that payment then they might have to forgo the payment made in the past and return the product or look at refinancing by taking another loan.
Balloon Payments vs. Adjustable-Rate Mortgages
A balloon loan is sometimes confused with an adjustable-rate mortgage (ARM). The borrower receives an introductory rate for a set amount of time with an ARM loan, often for a period ranging from one to five years. The interest rate resets at that point and it might continue to reset periodically until the loan has been fully repaid.
An ARM adjusts automatically, unlike some balloon loans. The borrower doesn’t have to apply for a new loan or refinance a balloon payment. Adjustable-rate mortgages can be a lot easier to manage in that respect.
Balloon Payments Example
For auto loans and mortgages, borrowers must usually make a large down payment to qualify.
Balloon mortgages allow qualified homebuyers to finance their homes with low monthly mortgage payments. A common example of a balloon mortgage is the interest-only home loan, which enables homeowners to defer paying down principal for 5 to 10 years and instead make solely interest payments.
Interest-only and other balloon mortgages are typically used by high-net-worth homebuyers who have enough capital to afford to pay down a large principal on a normal amortization schedule. Most borrowers of balloon mortgages don’t actually make the balloon payment when the low payment period ends. Rather, to avoid paying the large lump sum in cash, it’s common to refinance into a different mortgage or sell the house.
2. Auto Loans
Balloon payments are not as common for auto loans as they are for mortgages or business loans. However, lending restrictions are less stringent in the auto loan industry, so it’s a bit easier for consumers to take out this kind of loan. Many enter into balloon car loans thinking that they’ll see an increase in their income by the time the payment is due, often leaving themselves unable to pay down the lump sum.
While balloon car loans help secure lower monthly payments, consumers tend to take out these loans for the wrong reason. It’s important to remember that balloon loans aren’t actually more affordable—they only spread the total cost out in a different way. If there’s no absolute guarantee that your income will substantially rise, you should choose a loan that you can finance fully on your current income.
3. Business Loans
Businesses often use balloon loans for short-term financing needs or for commercial real estate purchases. For the business that needs working capital and is waiting for a large payment from a customer, a balloon loan can be an affordable way to provide gap financing.
Balloon loans can also be helpful for companies looking to move into a new office before selling their old one, as the deferred payment schedule allows time to sell the old property.
Balloon business loans pose the same risks to businesses as they do to consumers. For a business without a guaranteed income stream, it can be dangerous to take on a liability that demands a large lump sum payment.
Although refinancing is an option to get out of a balloon loan, there’s no promise that a lender will grant you a new loan. If your revenue drops off or your industry takes a hit, there’s a good chance you could be stuck with a large outstanding debt.
Pros and Cons of Loans with a Balloon Payment
Balloon loans are a complex financial product and should only be used by qualified income-stable borrowers. For example, this type of loan would be a good choice for the investor who wishes to minimize short-term loan costs to free up capital. For businesses, balloon loans can be used by companies that have immediate financing needs and predictable future income.
For the average borrower, it’s risky to take out a balloon loan with the assumption that your future income will grow. If you’re looking to purchase a house or a car, a better choice would be to make a monthly budget and take out a loan that you can pay on your current income.
Alternatively, you can save for a bigger down payment if you’re not in a rush to make a purchase that will let you purchase a more expensive asset with a lower monthly payment.
- Low or no initial payments
- Enables borrowers to access affordable short-term capital
- Can help cover financing gaps
- Costs of loan can be higher in the long term, especially if the loan is interest-only
- Poses more risk than traditional loans due to payment schedule
- There’s no guarantee that you’ll be granted a refinance to switch the debt obligation