A balloon payment is just what the name suggests - at least from a financial point of view.
It's a bigger payment on a consumer or business loan where in exchange for lower periodic payments early in a loan, the borrower agrees to make a larger "balloon" payment at the end of the loan.
Balloon loans are usually tied to amortized loans, like a mortgage loan, an auto loan, a personal loan, or a commercial loan. Basically, a balloon loan is established for a short period of time, with a percentage of the loan's principal balance outstanding amortized over the agreed-upon timetable. The loan is then usually paid off with the delivery of the larger balloon payment at the end of the loan period.
The benefit to the borrower is that for a long period of time under a balloon loan payment arrangement, the monthly loan payments will be significantly lower than they would without a balloon loan agreement.
Among other benefits, that buys them time to take the money they may have paid under a traditional loan agreement and use it for asset accumulation purposes, like investing in the stock market or real estate, or to attend college or graduate school and earn a degree that would translate into a bigger paycheck down the road.
From a dollars and cents point of view, a balloon loan is at least twice the amount of money the borrower would pay monthly before the balloon loan amount is due, and often much, much more, depending on the terms of the loan.
The goal of any borrower who agrees to a balloon loan repayment arrangement is to make sure they have the cash on hand when the balloon payment comes due. If not, the terms of the loan are in jeopardy, as is the borrower's credit health and home or auto, if the missed payments lead to repossession.
The downside risks come from the underlying asset (like a home or a business) that the loan proceeds are funding.
For example, if a homeowner takes out a balloon loan and the property depreciates in value before the balloon payment is due, that homeowner faces the likelihood of his or her home going "underwater" with the size of the outstanding loan higher than the value of the property.
How Does a Balloon Payment Work?
The best way to explain how a balloon payment works is to compare and contrast it with conventional loans.
Let's say you took out a traditional auto loan, with a series of fixed-price monthly payments, based on the loan principal and interest rates. With a conventional auto loan of $20,000 at a 5% interest rate. The loan period is 60 months.
Under this scenario, you, the borrower, would pay $377 per month in loan principal and interest, and would continue to do so every month (unless you pay down the loan more quickly) for the five-year loan period. After your last $377 monthly payment, the loan is repaid and you fully own the vehicle and owe no more to the auto lender. You'll have paid $2,645 in total interest.
In the same scenario, a balloon loan works differently. You still have the same five-year auto loan with a 5% interest rate. But add into the mix the balloon element with a 10-year amortization period, and your monthly payment falls to $212.13 per month. The balloon payment, which comes at the end of the loan, will be $11,453.20, with $3,968.00 of it as interest paid on the loan.
In exchange for the lower monthly payments over the life of the loan, you'll have to come up with the $11,453 balloon payment at the end of the loan.
Balloon loans often come with lower interest rates, so it's a good idea to sit down with multiple loan servicers and cut the best deal you can on balloon loan interest rates.
You do have options at the end of a loan that goes beyond paying the balloon loan and calling it a day.
You can . . .
- Deliver your balloon payment, satisfy the terms of the loan, and keep your vehicle.
- Refinance your loan and still keep your vehicle.
- Elect to trade in your auto but still be on the hook for the balloon loan under the loan terms (you'd need to check with your auto loan company for the specific terms.)
- Walk away from the deal and return your vehicle. If that's your call, you'll still be held liable for any loan amount remaining on the auto loan.
When Should You Choose a Balloon Payment?
Balloon payments may be the ultimate "risk/reward" consumer loan deal. Consequently, opting for a balloon payment usually only makes sense in the following scenarios:
- You want lower monthly payments, with lower interest rates, and want to qualify for higher loan amounts, under a balloon loan arrangement.
- You don't want the risk and uncertainty of an adjustable-rate mortgage (in the event you're looking for a mortgage loan.)
- You're a homeowner who expects to sell the home before the loan payment period is up, thereby benefiting from lower monthly payments and avoiding late-term balloon payments.
- You anticipate your salary or income to rise significantly in the coming years or you expect to have stronger credit in the coming years.
Basically, if you don't think you can handle an ultra-large payment at the end of the loan, or you expect to be earning less money in several years (i.e., you're heading into retirement or suffering from a long-term illness) you'll want to shy away from balloon loans.
Pros and Cons of a Balloon Mortgage Loan
By and large, taking out a balloon mortgage loan means taking a good look at your financial situation, your long-term financial goals, and the deal you strike with a lender.
These "pros and cons" can help clarify that situation:
Pros of a Balloon Mortgage Loan
The Amortized Loan Scenario Is in Your Favor With a balloon mortgage loan, you're benefiting from the 30-year loan amortization that comes with balloon loans. As long as you sell the house before the balloon payment comes due or refinance your mortgage loan (or if you wind up paying the balloon loan in the end), a balloon loan usually translates into lower monthly mortgage loan repayments.
They're Easier to Get Compared to traditional mortgage loans, balloon mortgage loans are easier to obtain and you can obtain a larger loan amount, with a balloon loan provision attached.
If You're Looking to Sell the House Since you'll be paying lower monthly amounts with a balloon amount, you'll also be paying less interest on the home loan, as well. That gives you a better rate of return once you do sell the home before the balloon payment is due.
Cons of a Balloon Mortgage Loan
A Big Mortgage Loan Payment Looms If you plan to remain in your home for the long haul, you'll always have the huge balloon payment hanging over your head. That may trigger bouts of worry and anxiety, especially as you draw closer to the balloon payment date, and you've suffered a financial setback that puts that large loan payment in jeopardy.
Easy Access to Credit Can Lead to Trouble Since it's easier to qualify for a balloon mortgage loan, you may bite off more than you can chew financially, and end up taking on more home than you can afford, even with lower interest rates. That could lead to late or no payments made, and if you lose your job or suffer another financial setback, your finances and credit health could suffer serious damage.
If You Can't Refinance or Sell the Home It's 'Pay or Bust.' There's really no way around paying the balloon loan amount if you don't refinance or can't sell the home. If economic conditions work against you, and rates go higher and home sales erode, you could be stuck paying the piper, whether you planned on that outcome or not.
The Takeaway on Balloon Loans
Balloon loans may make sense if you're into lower monthly loan repayments, can handle the larger balloon payment at the end of the loan, or get creative with your loan before the balloon payment comes due.
If not, you're courting big household financial trouble if you can't cover the balloon loan repayment - trouble that could set you back financially for years to come.
It's never too late - or too early - to plan and invest for the retirement you deserve. Get more information and a free trial subscription to TheStreet's Retirement Daily to learn more about saving for and living in retirement. Got questions about money, retirement and/or investments? Email Robert.Powell@TheStreet.com.