What Is a Balloon Payment and How Does It Work?
What Is a Balloon Payment and How Does It Work?
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A balloon payment is a lump sum paid at the end of a loan's term that is significantly larger than all the payments made before it. Balloon loans allow borrowers to have lower payments at the beginning of a loan in exchange for a larger (balloon) payment at the end of the loan's term. In general, these loans are better for borrowers who have excellent credit and a substantial income.
What is a balloon payment?
Balloon payments are generally defined as loan payments toward a balloon loan that are at least twice as large as regular payments.
By requiring one large lump sum payment at the end of a loan, balloon loans allow borrowers to keep their monthly loan repayments low at the beginning of the loan.
Balloon loans usually have shorter terms than traditional installment loans, with the balloon 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.
Examples of balloon payments
Balloon payments are most commonly used with the following types of loans, though these products may look different than their traditional counterparts.
Balloon mortgages allow qualified homebuyers to finance their homes with low monthly mortgage payments at first.
A common example of a balloon mortgage is the interest-only home loan, which enables homeowners to defer paying down the principal for three 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 high credit scores and 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 first.
Businesses often use balloon loans for short-term financing needs or for commercial real estate purchases.
For a 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 the old one, as the deferred payment schedule allows time to sell the old property.
Balloon loans pose the same risks to businesses as 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.
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 borrowers 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.
Pros and cons of balloon payments
Frequently asked questions
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.
Balloon loans can be used by businesses that have immediate financing needs and predictable future income.
Yes, balloon payments are a legal way for lenders to structure loans so that they’re more affordable up front for borrowers. However, that doesn’t mean they aren’t without risks, and lenders will still need to make the terms, rates and eventual lump sum payment clear to the borrower.
If you took out a loan with a balloon payment, you can avoid paying off the balloon payment by refinancing the loan first. Or, if you used the loan to purchase a home, you could sell the home if you are unable to make the payment.
If you can’t avoid the lump sum payment, be sure to use the extra funds you're saving to build up enough funds to repay the lump sum you'll owe.
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 a lower monthly payment.