This is the term used for an unusually large payment that is paid at the end of a balloon loan. This loan gets its name because the final payment amount is a “balloon” or quite significant. It is generally more than double the loan’s average monthly payment.
This is also, typically, short-term. The principal is not fully amortized, or spread out, over the course of the loan. As a result, a large balance is due at the end of the term. Balloon loans are available for mortgages, auto loans, and business loans.
Balloon mortgages customarily have lower monthly payments than conventional loans. It is attractive for qualified borrowers to finance a home with the intention of refinancing their mortgage or selling the house before the payment is due.
Some balloon mortgages come with a reset provision where the loan converts to a fully-amortized mortgage, or into a traditional loan. There are known as “convertible” balloon mortgages.
Balloon mortgages are usually fixed-rate mortgages. The payments are typically based on a 30-year amortization schedule. In other words, the interest and principal payments are spread out over 30 years or 360 months. A buyer can choose the balloon term, which generally ranges from five to seven years.
The buyer will pay his monthly mortgage as if it was a 30-year loan. However, at the end of the five to seven years, the balloon payment will be the remaining balance of his loan.
Let’s say a buyer takes out a balloon loan of $100,000 for seven years at 4.5% interest. His monthly payment is $506.69. At the end of the seven years, or after 84 monthly payments, his balloon payment would be $87,352.12.
Imagine being able to afford a $500 monthly payment. However, in one lump sum, you are required to pay over $87,000. This balloon payment is usually a shock to most borrowers. Understandably, balloon loans are riskier than traditional loans.
Note that this type of loan is dangerous if the housing market suddenly falls before you can sell your home. This may result in a “short sale.” In other words, the sale of the house does not cover or pay off all the loans or liens against the property.