What Is a Balloon Payment and How Does It Work?

A balloon payment is a lump sum paid at the end of a loan's term that is significantly larger than all of the payments made before it. On installment loans without a balloon option, a series of fixed payments are made to pay down the loan's balance. Balloon payments allow borrowers to reduce that fixed payment amount in exchange for making a larger payment at the end of the loan's term. In general, these loans are good for borrowers who have excellent credit and a substantial income.

Balloon Payments Explained

Balloon payments are generally defined by being at least twice as large as regularly scheduled payments. By making one large lump sum payment, balloon loans allow borrowers to lower their monthly loan repayment costs in the initial stages of paying back a loan. Balloon loans usually have shorter terms than traditional installment loans, with the large payment typically due after a few months or years. Balloon payment structures are most commonly used for business loans, though they are also available on auto loans and mortgages.

Despite their reduced initial payments, balloon loans are riskier than traditional installment loans because of the large payment due at the end. As such, most lenders will only provide these loans to consumers and businesses with excellent credit, sufficient cash on hand and stable income streams. A handful of states have banned consumer balloon payment mortgages and placed significant restrictions on balloon auto loans. For auto loans and mortgages, borrowers must usually make a large down payment to qualify.

Takeaways

  • Lower monthly payments than traditional loans
  • Higher risk due to lump sum payment
  • Usually restricted to most creditworthy and income stable borrowers

Mortgages

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 paying 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.

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.

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 for 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 who 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—which will let you purchase a more expensive asset with lower monthly payment.

Pros:

  • Low or no initial payments
  • Enables borrowers to access affordable short-term capital
  • Can help cover financing gaps

Cons:

  • 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

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