A balloon payment is the last large payment due at the conclusion of a balloon loan term.
What is a balloon payment?
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.
Why choose a balloon loan?
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.
How does it work?
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.
Here’s an example:
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.
Risks of a Balloon Loan
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.