What Is A Balloon Loan

What Is a Balloon Loan?

A loan that does not fully amortize over its term is known as a balloon loan. Due to incomplete amortization, a balloon payment must be made at the conclusion of the term to cover the outstanding loan balance.

Because balloon loans usually have lower interest rates than loans with longer terms, they can be appealing to borrowers with shorter terms. But because there’s a chance the loan could reset at a higher interest rate, the borrower needs to be aware of the risks associated with refinancing.

A balloon loan is a brief loan with partial amortization over the loan’s term.
For a predetermined number of payments, payments are either interest-only or primarily interest plus some principle.
The remaining loan balance is due all at once in a balloon payment.
Balloon loans are popular in construction and home flipping.

How a Balloon Loan Works

Mortgages are the loans most commonly associated with balloon payments. Usually, balloon mortgages have brief terms of five to seven years. But the monthly installments during this brief period aren’t designed to pay back the whole loan. Rather, the loan’s monthly payments are computed as though it were a conventional 30-year mortgage.

Nevertheless, a balloon loan’s payment schedule differs greatly from that of a conventional loan. Only a portion of the principal balance remains unpaid by the borrower at the end of the five- to seven-year term; the remaining amount is then due in full. At that point, the borrower has two options: either sell the house to pay the balloon payment or refinance the mortgage by taking out a new loan to cover it. Alternatively, they may make the payment in cash.

A balloon loan default will have a bad effect on the borrower’s credit score.

Example of a Balloon Loan

Assume someone obtains a $200,000 mortgage with a four-year term and a seven-year term. 5% interest rate. Their monthly payment for seven years is $1,013. They owe a $175,066 balloon payment at the conclusion of the seven-year term.

Special Considerations for a Balloon Loan

Certain balloon loans, like a five-year balloon mortgage, have a reset option that lets you recalculate the amortization schedule based on a new term and reset the interest rate based on current rates at the end of the five-year term. The lender expects the borrower to make the balloon payment or refinance the loan before the original term expires if a balloon loan does not have a reset option.

A balloon loan might make sense if interest rates are extremely high and the borrower doesn’t intend to stay in the house for a long time (in the case of a mortgage). However, there is a significant risk when the loan term expires. The debtor must practice fiscal restraint in order to accumulate sufficient funds for the balloon payment. Furthermore, when the borrower needs to refinance, interest rates may be higher if they are currently low or are predicted to rise.

Pros and Cons of Balloon Loans

Because very little of the principal is being repaid, the monthly payments are much lower than those of a traditional amortized loan, which may allow the borrower to borrow more than they otherwise could.
not fully experiencing the effects of high interest rates because, as previously mentioned, the payment is lowered due to the limited principal paydown
Usually lasting five to seven years, the terms allow the borrower to refinance at a potentially lower interest rate rather than committing to decades of payments at a high rate.

However, having a loan with a massive balloon payment that covers the majority or all of the principle has obvious drawbacks as well.

Defaulting on the loan in the event that the borrower is unable to secure financing for the balloon payment from their current lender or another source and is unable to raise the necessary funds to settle the principal balance
failing to sell the property for a sufficient amount to cover the balloon payment and subsequently going into default on the loan
Refinancing the balloon loan successfully will result in higher monthly payments due to the higher interest rate (this will be especially true if the new loan is amortized and includes principal repayment).

There is an additional risk involved in choosing a balloon loan. The tiny initial interest-only (or primarily interest-free) monthly payment might easily fool someone into taking on more debt than they can reasonably afford. That is also a potential road to financial ruin.

What Industries Use Balloon Loans?

Balloon loans are common among home flippers and the construction sector. The low initial payments are used by contractors or real estate investors to finish projects in the hopes of selling them before the balloon payment is due.

What Happens if You Can’t Pay Your Balloon Payment?

Defaulting on your balloon payment carries the same consequences as defaulting on any loan: property repossession and foreclosure. Defaulting will destroy your credit history and make it more difficult for you to get loans in the future.

Can You Refinance a Balloon Loan?

Yes. In an effort to benefit from the lower interest-only period at first, many people intend to refinance a balloon loan before the balloon payment is due in the hopes that interest rates will drop later. However, there is a risk involved—due to the volatility of interest rates, you might refinance at a rate higher than you would have if you had initially opted for a fixed-interest loan.

The Bottom Line

Because balloon loans have low repayment amounts, they can provide flexibility during the first loan term. However, before the payment is due, borrowers should arrange to pay off the remaining balance or refinance. These loans do have a purpose; they can save a lot of money for borrowers who only need to borrow money temporarily. Be realistic about your loan needs before borrowing. Article Sources: Investopedia mandates that authors cite original sources to bolster their claims. These consist of government data, original reporting, white papers, and conversations with professionals in the field. When appropriate, we also cite original research from other respectable publishers. You can read more about the guidelines we adhere to when creating impartial, truthful content in our

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FAQ

How does a balloon loan work?

A balloon loan is a brief loan with partial amortization over the loan’s term. For a predetermined number of payments, payments are either interest-only or comprise a combination of principal and interest. What’s referred to as a balloon payment is the remaining loan balance that is due all at once.

Is it a good idea to get a balloon loan?

But take caution: Although a balloon loan could result in you taking on more debt or ending up upside down on your loan in the future, a lower monthly payment might be perfect for your budget.

Are balloon payments a good idea?

To reduce your monthly payments and buy a better car, it can be a good idea to include a balloon payment or residual value in your loan or lease.

Read More :

https://www.investopedia.com/terms/b/balloonloan.asp
https://www.consumerfinance.gov/ask-cfpb/what-is-a-balloon-payment-when-is-one-allowed-en-104/