Balloon payment – What is a balloon payment?
A balloon payment, as the name suggests, is a large payment that is due at the end of a balloon loan.
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A balloon loan is a type of loan that doesn’t fully amortise before the end of the loan term. When the loan has not been fully amortised, a balloon payment is needed to cover the outstanding balance that is due.
Balloon payments and balloon loans – how do they work?
As already said, a balloon payment is made at the end of a balloon loan. Balloon payments are a necessary part of balloon loans as their payment structure is significantly different from a traditional loan. Normally, the loan’s repayment period covers the entire cost of the loan (plus interest). For example, someone may borrow £200,000 and pay the loan back at £12,500 per year. The loan would therefore be for 16 years (not including interest).
However, if this was a £200,000 balloon loan, the repayment period would be a lot shorter and the rest of the loan would all be due at once. Suppose that the repayment period was 4 years. Therefore, the borrower would only have paid off 25% of the principal balance and suddenly need to pay £150,000 at once (not including interest they have accumulated). This remaining £150,000 would be a balloon payment.
Balloon payments and mortgages
Balloon payments are most commonly associated with mortgage loans. Balloon mortgages usually have short terms that range from between five to seven years, rather than traditional 30-year loans. When the repayment term is complete with a balloon mortgage, the borrower may sell the home to cover the balloon payment that is due or take out another loan to finance the lump payment. If possible, the balloon payment may also be paid in cash.
Advantages of having a loan with a balloon payment
Sometimes there can be advantages of entering into a balloon loan with a balloon payment due in the foreseeable future. Having the balloon payment after five to seven years of what would otherwise be a 30-year loan may actually help some borrowers. If the interest rates are high at the time when they take out a loan, a balloon loan doesn’t commit them to a long time of paying back the loan at that high rate. Once the date of the balloon payment nears, the borrower can refinance to cover that payment, and possibly borrow money at a lower interest rate.
Also, balloon loans have much lower monthly payments than traditional amortized loans. This is because very little of the total borrowed is repaid in instalments and rather it is paid as a balloon payment. Lower monthly payments therefore allow borrows to take out loans that they otherwise wouldn’t be able to.
Disadvantages of having a loan with a balloon payment
However, there are also risks associated with balloon loans. Borrowers may find that they’re unable to convince their lender, or another lender, to finance their balloon payment. Therefore, they cannot make a full principle payment to pay off their debt.
If you take out a balloon loan, it is possible that you’ll need to take out another loan to fund your balloon payment. Whilst this can be an advantage if interest rates have dropped since you took out the loan, it can also be a problem if the interest rates have risen. You may find yourself needing to take out another loan with higher interest to fund your balloon payment.
If you take out a balloon mortgage, it’s important to be aware of fluctuations in property prices. It may be necessary to sell your proper in order to pay the balloon payment, but, if the property values have fallen, your sale may not cover the full payment. You then run the risk of defaulting on the loan.