Balloon Payment ☑️ Explained for Dummies

What is a balloon payment?

A balloon payment refers to the significantly large balance payable by the borrower at the end of a loan term. The borrower is required to pay the balance in full at the end of the loan term or refinance the outstanding amount. It is called a balloon payment because of the large size of the final payment - inflated like a balloon. It is also called a balloon loan or a balloon payment loan, while, about a secured loan like a mortgage, a balloon payment is also referred to as a balloon mortgage, or balloon payment mortgage.

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General facts about balloon payments

A balloon payment is an option when a home mortgage, vehicle (auto) loan, or business loan is considered. However, most homeowners are not able to pay a large balloon payment at the end of the mortgage term. Hence, balloon loans are not very common in the financing of residential real estate. Contrarily, these loans are more common among commercial (business) borrowers who need immediate cash and who are able to make a huge final payment.
The structure of a balloon payment loan involves a final payment which is much larger than the previous (earlier) payments on the loan. For instance, the loan can be structured in such a way that the early payments mostly cover the interest owed on the loan, with the balloon payment reflecting the principal amount of the loan. Put differently, only a small part of the principal loan amount is amortised during the period of the loan.
A balloon payment can be compared to a deposit that a borrower pays to a bank or finance company at the end of the loan term instead of paying a deposit upfront.
Due to a major portion payable at the end of the loan tenure, balloon loans have repayment risk. Hence, individuals with an excellent credit record, good cash flow, and a sustainable income usually qualify for balloon payment loans.
Sometimes, the final balloon payment is refinanced (rolled into a new loan). This means that the borrower pays off the balloon loan using the new loan. Usually, the new loan has a lower interest rate and no final balloon payment.

Examples of balloon payment loans

As mentioned, balloon payment loans are usually used in vehicle (auto) loans and business loans, and to a lesser extent in mortgages.

Mortgages

Typically, regular mortgages (also referred to as traditional home loans), are fully amortised, implying that the regular instalments include a certain amount of the principal amount and some interest amount. Usually, monthly payments (instalments) are high. At the end of the loan term, the entire mortgage (principal amount as well as interest) is paid off. Contrarily, balloon mortgages are not completely amortising. The monthly instalments (interest inclusive) are very low. Hence at the end of the loan term, the mortgagor (the borrower) is still owing a huge sum (the balloon payment). Therefore, a balloon mortgage is seldom used for traditional long-term loans - 15 to 30 years, because mortgagees (lenders) are not willing to wait that long to get their money back. Mortgagees prefer shorter loan terms, for instance, five-year to ten-year terms. If considering a balloon mortgage, prospective homeowners need to consider whether and how they can make the balloon payment at the end of the loan term.

Vehicle (auto) loans

Loans with a balloon-payment option for vehicles allow prospective buyers affordable monthly instalments. Borrowers also do not have to pay a sizeable deposit upfront. However, prospective buyers need to know how much the amount of the balloon payment will be, the date when the payment will be due, and how they will afford the balloon payment. The worst-case scenario is that a borrower’s vehicle could be repossessed when he or she is not able to pay the balloon payment. Lenders are usually comfortable providing vehicle loans with the standard auto loan term of up to six years. When explaining ‘how vehicle finance with a balloon payment works,’ Nedbank explains that a borrower’s ‘loan finances only a percentage of the purchase price.’ This means that the capital portion of the monthly instalments is calculated on a lower amount, resulting in more affordable payments. For example, if a person buys a car for R600 000, with a balloon payment of 25 percent, his/her monthly instalments will settle a capital balance of R450 000. The balloon payment will be R150 000, payable at the end of the loan term - usually 72 months (6 years). Bear in mind, during the loan term, the interest portion of the monthly instalment would still be calculated on the actual purchase price of the vehicle - R600 000. Buying a vehicle with a balloon payment loan is an appropriate option for individuals who urgently need to acquire a vehicle but cannot immediately afford high monthly instalments. Regarding vehicle insurance, ensure that the insurance covers the replacement value of the vehicle, as well as shortfall cover for the loan. If the vehicle is lost to theft, fire, or an accident, a shortfall will enable a borrower to take care of the balloon payment.

Business loans

Business loans allow businesses to cope with cash-flow constraints, and to provide working capital. A business loan can also be used to acquire equipment to improve the production and services of a business. Banks and other financial institutions often consider businesses - with a proven financial history and approving credit record - less risky than individual consumers for business loans. Typically, a business can strategically use a balloon payment loan to cover finance needs for the short term. A business may use a balloon loan to pay off the loan prior to the end of the loan term.

Options to get rid of a balloon payment loan

There are various options available to a borrower to get rid of a balloon payment. For instance:

The balloon loan can be discontinued by paying it off in full.
If possible, the payment can be refinanced.
Negotiate with the lender to repurpose the balloon loan into a different type of loan. Other than that, the borrower can negotiate the loan amount, terms, and conditions (T&Cs) of repayment, and interest rates.
A borrower can also negotiate an extension, which, similar to refinancing, changes the terms of the previous loan. Although, an extension will simply move the timing of the balloon payment forward, implying having the same payment terms as previously, but with different obligation dates.
A borrower may be allowed and able to pay a portion of the debt early. Any amount paid which exceeds the interest assessment will be applied to the principal balance. However, check with the lender about possible prepayment penalties or fees.
‘Take another loan equivalent to the outstanding final payment - this way [the] borrower can buy time to pay the amount gradually.’ (WallStreetMojo)
If required, sell assets or investments to repay the balloon payment.
About a business loan, surplus cash flow can be used to repay the debt or part of the debt.

Advantages of a balloon payment

A balloon payment loan has some advantages. For example:

In comparison to other types of loans, balloon payments have lower interest rates.
The initial monthly instalments are small.
Compared to traditional loans, the term of the balloon loan is usually shorter.
From lenders’ point of view, more business can be generated with balloon loan structures.
Balloon payments can be refinanced or restructured.
A borrower enjoys an advantage with a balloon payment if property values continue to increase if the borrower’s available income and credit capacity do not decline, and if interest rates do not rise.

Disadvantages of a balloon payment

Balloon payments can cause problems in a falling housing market. For instance, when the value of houses declines, homeowners may be unable to sell their property for enough to pay off the balloon payment. The homeowners might be unable to sell at any price. As a result, a homeowner may have no choice but to default on the balloon payment and the lender may eventually seize the property.
Furthermore, non-payment of the balloon amount may result in the sale of other investments and fixed assets to cover any outstanding liabilities regarding the balloon payment.
Defaulting on the balloon payment, significantly decreases the credit score of a borrower, making it difficult to obtain future loans.
Balloon payment mortgages have limited application and scope as the risk of default is high.
Depending on the amount of equity that has been covered, it may be difficult to refinance balloon mortgages and vehicle (auto) loans. If a balloon payment loan only requires payments of interest early on, the borrower may have little (or zero) equity in the asset, despite making regular payments for years.
Balloon mortgages can make housing seem misleading and affordable.

Note: This article does not constitute investment, financial or trading advice. Please obtain the advice of a professional, reputed, and regulated broker before making trading and investment decisions.