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Balloon Payment Definition #adessonews

What Is a Balloon Payment?

A balloon payment is a large payment due at the end of a balloon loan. This type of loan intentionally structures earlier payments during the loan term to be smaller and for later payments—often just the last payment—to be higher. This type of loan can a mortgage, commercial loan, or any other type of amortized loan. It is considered similar to a bullet repayment.

Key Takeaways

  • A balloon payment is a type of loan structure where the last payment on an installment plan is intentionally larger than prior payments.
  • Balloon payments can be implemented for home mortgages, auto loans, or business loans.
  • Borrowers often have lower initial monthly payments under a balloon loan, and these types of loans are quicker to underwrite.
  • The assessed interest rate is usually higher under a balloon loan, and only borrowers with higher creditworthiness are often considered.
  • A balloon payment may simply be a weighted payment amount or, under an interest-only payment plan, be the full balance of principal.

What are Balloon Payments?

Understanding Balloon Payments

The term “balloon” indicates that the final payment is significantly large. Balloon payments tend to be at least twice the amount of the loan’s previous payments. Balloon payments are more common in commercial lending than in consumer lending because the average homeowner typically cannot make a very large balloon payment at the end of the mortgage.

Most homeowners and borrowers plan to either refinance their mortgage as the balloon payment nears, or sell their property before the loan’s maturity date. In addition, businesses often leverage balloon loans to take advantage of smaller upfront payments to cover short-term financing needs before paying the debt before the balloon payment occurs.

Balloon payments are often packaged into two-step mortgages. In this financing structure, a borrower receives an introductory and often lower interest rate at the start of their loan. Then, the loan shifts to a higher interest rate after an initial borrowing period.

Balloon Payment Examples

A balloon debt structure can be implemented for any type of debt. It’s most commonly seen in the industries below, though it often differs from traditional loans in each sector.

Mortgage

A borrower can secure a balloon mortgage where the final payments of the mortgage are higher than the initial payments. A lender is often not willing to wait the traditional 15 or 30 years mortgage term; for balloon mortgages, lenders often implement five-year to ten-year term.

Interest-only balloon mortgages are often only available to high net worth individuals who have sufficient cash flow to afford a large down payment. These types of loans are often taken out with the intention of being refinanced prior to having to make the balloon payment.

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.

Auto Loan

Balloon loans are not as common when used as auto loans. However, this structure works especially well for individuals who have an urgent need to secure a vehicle but may not have the current income to support higher monthly payments. Often, a borrower needs a car to support their source of income.

As lending restrictions are often not as stringent in the auto loan industry, it is often easier for a borrower to secure this type of loan. Lenders are usually comfortable with the standard car loan term (up to 6 years).

Business Loan

It is usually easier for a business to secure a balloon loan if the business has a proven financial history and favorable creditworthiness. Due to the nature of a balloon loan requiring substantial capital at the end of the term, businesses are often in a better position to raise sufficient money through operating revenue to extinguish their debt; for this reason, lenders often consider businesses less risky for business loans than individual consumers.

Balloon payments can be strategically used by a business to finance short-term needs through short-term debt. A business may draw on a balloon loan with no intention of holding the debt through the end of the term. Instead, a company can receive debt financing, utilize those funds in the short term, and intentionally pay back the loan in full before the debt being due.

Extinguishing Balloon Payments

A borrower has a couple of ways to get rid of their upcoming balloon payment. In addition to extinguishing the debt by paying off the balloon payment, a borrower can:

  • Refinance the loan. A lender may be willing to work with a borrower to repurpose the debt into a different loan vehicle or modify the terms of the original agreement.
  • Sell the underlying asset. If the balloon payment is due to the purchase of an asset, a borrower may be forced to liquidate their holding to avoid defaulting on their loan.
  • Pay principal upfront. Though not required, a borrower may be able to pay a portion of the debt early. Any payment made more than the interest assessment will be applied to the principal balance. Check with your lender to ensure there are no prepayment penalties or fees.
  • Negotiate an extension. Similar to refinancing, an extension changes the terms of the prior loan. However, instead of receiving a new deal, an extension will simply push out the timing of the balloon payment. You’ll likely have the same payment terms as before but with different obligation dates.

Balloon loans often require collateral. For home or car loans, the lender may receive a lien on your property. Should you default on your loan and not be able to satisfy your balloon payment, the lender often has a legal claim to recover their debt.

Advantages of Balloon Payments

The obvious advantage of balloon payments is the low initial payment requirement. The monthly balloon payment amount during the fixed period is often less than the payment amount of a fully amortized loan. The timing of the payment size may mesh well with the borrower’s income expectations. As the borrower’s salary increases due to career progression, their debt obligation will subsequently rise as well.

A balloon note or loan often has a shorter underwriting process compared to other loans. For this reason, there may be lower administrative or transaction fees in securing the loan. A borrower may also not be required to show as much documentation for this type of loan, as balloon mortgages often do not require a home appraisal as part of loan closing.

A balloon payment structure is also strategically advantageous for some users. For example, individuals who flip houses can secure a balloon mortgage and be locked into a lower upfront monthly payment. By the time the house has been remodeled, the construction project is complete, and the borrower is ready to sell, the balloon payment amount may be due. This allows borrowers to preserve future cash flow for other purposes.

Disadvantages of Balloon Payments

Balloon payments can be a big problem in a falling housing market. As house prices decline, the odds of homeowners having positive equity in their homes also drop and they might not be able to sell their homes for as much as they anticipated. For home flippers, this means potentially being stuck with a high interest rate loan should a home sale stall.

Borrowers often have no choice but to default on their loans and enter foreclosure, regardless of their household incomes, when faced with a balloon payment they cannot afford. This potentially results in the loss of the borrower’s home or liquidation of the asset to extinguish the debt. You may be able to take out another loan to cover an upcoming balloon mortgage, but this compounding debt structure puts tremendous strain on a household’s finances.

Balloon mortgages and auto loans may be difficult to refinance depending on the amount of equity that has been paid. Often, these loans may only pay interest first. In this case, you may have little-to-no equity in your asset although you’ve been making consistent payments.

These types of loans are sometimes harder to qualify for. Because principal payments are deferred, lenders often prefer borrowers with a high credit score or high down payment. In addition, to compensate for the flexibility of the principal obligation and increased risk for the lender, lenders usually charge higher interest rates for balloon debt compared to other types of loans.

Balloon Payments

Pros

  • Lower upfront payments compared to other loan types

  • Greater buying power during low income periods with increasing debt obligation during higher income periods

  • Shorter underwriting process compared to other loan types

  • Greater strategic potential for certain industries

  • Fewer documentation requirements for underwriting

Cons

  • Greater risk in foreclosure if you can’t meet your loan requirement

  • Slower build-up of equity resulting in potential difficulty in refinancing loan

  • Harder to qualify for due to higher credit preferences by lenders

  • Higher costs (i.e., higher interest) due to the riskier nature of the loan from the lender’s perspective

What Is a Balloon Payment?

A balloon payment is a lump sum principal balance paid towards the end of a loan term. Instead of paying down principal over the course of a loan, a balloon payment is an inflated one-time amount owed, usually after interest-only payments have been remit over the life of the loan.

How Does a Balloon Payment Work?

A balloon payment is just like any other loan installment payment. The only difference is the amount of the payment is often substantially higher than the previous payments, and the balloon payment is often the last payment as part of an installment plan. A lender will usually collect payment in the same manner as it had been during the loan when only interest was being paid.

A typical balloon debt or note requires only interest to be paid each month until the final month of the loan term. In the final month, the entire principal balance is due. The interest paid each month is often a fixed amount as the principal balance does not change and the interest charged each month is not capitalized as part of the loan but instead paid off immediately.

Is a Balloon Payment Legal?

Yes, a balloon payment is a legal debt instrument. A lender can intentionally structure a loan to help a borrower manage lower upfront monthly payments. However, the borrower must be aware of the long-term obligation of paying down the principal balance all at once at the end of the loan.

Are Balloon Payments a Good Idea for Cars?

A balloon payment may be suitable for some lenders looking to secure a car loan. The borrower will likely pay a higher interest compared to other loans, and the borrower may have difficulty converting or refinancing the loan to a different type towards the end of the loan term.

However, a balloon payment will allow a borrower to have a lower monthly car payment as the borrower will only pay interest for many of the payments. This also buys the borrower time to save money if they urgently need a car but may not be able to afford a higher monthly payment.

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