When buying anything from a car to a house, you might choose a loan with a balloon payment at the end of the finance term. But, before entering such agreement, be sure you can answer the following question: What is a balloon payment?
Simply put, a balloon payment is a massive, single payment that is due as the final payment of a balloon loan. It is most often associated with financing for a mortgage, business or any other amortized loan such as a car payment. Balloon loans only require borrowers to make interest payments the first few years of the loan. Unlike amortized loans, with a balloon loan you are only making interest payments and paying nothing towards the principle. In this article, we will explain what is a balloon payment.
The Concept of a Balloon Payment
Balloon payments have been around for as long as people have been purchasing large-ticket items on credit in the 1930s. The word balloon relates to the fact that the last payment has blown up, and is larger than previous payments.
Balloon payments can require borrowers to pay twice the amount of the loan’s prior payments. This means that borrowers with a balloon payment have to come up with hundreds, sometimes even hundreds of thousands, in order to satisfy the terms of the loan.
Balloon payments are more common in commercial financing. However, lenders who make loans for such things as home and automobile purchases might also use them.
Balloon Loan vs. Two-Step Mortgage
When purchasing a home, balloon payments are often wrapped into what is known as a two-step mortgage. In this type of loan, the borrower pays a fixed-interest rate for a specified number of years. When the loan term is complete, the loan resets, and the balloon payment rolls over into a new loan or an amortized loan at whatever the current interest rate is. Keep in mind that in the two-step mortgage, the loan reset is not automatic. The reset often depends on whether the borrower has made his payments on time, and if his income has remained stable and consistent.
Balloon Loan vs. Adjustable Rate Mortgage
What is a balloon loan? Be sure and not confuse it with an adjustable rate mortgage or ARM. The borrower’s interest rate is set for a specific number of years under ther terms of an ARM, usually from one to five. When that time period has passed, the interest rate changes. Such a reset may happen several times over the course of an ARM.
Since the average home purchaser most likely will be unable to come up with a large balloon payment at the end of their mortgage term, even though they may have paid down a sizable portion of the principle over the loan terms, many either make plans to refinance the mortgage before the balloon payment is due or simply sell their home before they are required to make that final payment.
Advantages and Disadvantages of Balloon Payment Loans
When considering what is a balloon payment and if it is right for you, keep in mind that only qualified borrowers who have a stable (and steady) source of income should use this type of lending arrangement. It can be risky for the average borrower to take out a balloon payment loan with the hope that their future income will cover the cost of the loan’s final balloon payment.
The housing market also plays an important role in balloon payment mortgages. A major disadvantage of balloon mortgages is readily important when the housing market slumps, leaving homeowners with negative equity in the home and few options other than foreclosure when the balloon payment comes due.
Advantages of Balloon Payment Loans
Balloon loans do have some advantages, which you should consider when asking what is a balloon payment, including:
- Low or even no initial payments;
- Access for borrowers to short-term capital;
- Provide gap financing;
Disadvantages of Balloon Payment Loans
The following are some of the disadvantages associated with balloon loans. One should consider them when answering the question what is a balloon payment.
- Cost of the loan can be higher in the long-term, especially if you are paying interest-only;
- More risky than traditional loans because of repayment schedule;
- There is no refinance guarantee that would allow you to change loan structure;
Recommended read: What Is a Jumbo Loan?
The answer to the question what is a balloon payment quite naturally varies from borrower to borrower. Lenders often pitch balloon loans by pointing out that the borrower can refinance the loan before the balloon payment it due. While that may be true, refinancing is not guaranteed. If you find you do not quality for refinancing as your balloon payment nears, you may have to sell your home in order to satisfy the obligation.
However, if your financial situation is secure, and you anticipate it staying that way, a balloon mortgage might be perfect for you. You would be paying only interest on the loan every month until the balloon payment comes due. Keep in mind though that you are also not building up any equity in your home with a balloon mortgage. And equity, in the form of a home equity line of credit, can come in handy in an emergency situation and provide you with a ready source of cash to meet any unanticipated needs you may have.