What are Balloon Payments?
A balloon payment is a type of loan in which small installments are paid during the period of the loan and a final big repayment is done at the end. This final payment because of its large size is called a balloon payment. These loans are generally for a short term period and interests are being paid during the loan period and final repayment is done for the outstanding principal. These are often seen in the mortgage market, the reason being an advantage of lesser initial payment.
Let us look at the example below for Balloon Payment
Example of Balloon Payment Calculations
In this Balloon Payment calculation example, let’s say Mr. Z takes out a balloon mortgage of $417000 which is to be paid in two years. What happens in the normal mortgage scenario that the borrower will pay a series of equal installments which will consist of some principal amount and some interest amount so that by the end the borrower has paid the entire loan along with the interest.
However, in case of the balloon payment calculation, the monthly payment will be very low and will consist of a very small amount of principal repayment and at end of the tenure, the borrower will pay a huge amount so that all his dues along with interest gets cleared. Prepare the payment schedule of Mr. Z considering the interest rate to be 2 % and consider the 1st repayment date to be 1st October 2015. The installment which will be paid every month will be $ 1500 inclusive of interest.
Balloon payment calculation schedule for the loan taken by Mr. Z of $ 417000 for two years at the rate of 2 % is as follows:
In the above schedule, we can see that a huge payment of installment of $ 398805.13 has been made and at the end, the liability comes to zero. Moreover, the principal component in installment apart from the last one is coming very minimal.
- It comes with lower interest rates, so one has to make small monthly payments.
- A good option for the person having cash crunch but are expecting inflows in the near future.
- One may qualify for a bigger amount of loans than they do in the normal loans.
- The loan tenure will be generally shorter. So the repayment default may cause in the selling of investment or houses as there is not much time to think for other avenues.
- More chances of default resulting in more chances of adverse effect in credit rating which may impact on the sanctioning of future loans or sanctioning with affordable terms.
- Very high burden of cash outflow at the end when the final payment is done which can impact the liquidity adversely resulting in an increase in toughness to complete the business cycle.
- There can be other risks like credit market risk, interest rate risk, collateral impairment risk, the time required and necessary to refinance a balloon payment.
- There may be prepayment or closure charges.
Important Points to be Considered While Taking Balloon Payments
- Balloon loans are more often seen in commercial lending as a comparison to consumer lending because of the fact that it will be tough for a homeowner to make a huge payment at the end.
- Balloon loans are taken for a very short period, unlike the normal loan.
- Only a small portion of the principal amount is being amortized during the period of the loan.
- This type of arrangement can be risky for a falling housing market as one takes the loan with the projection of the resale value of the house at the end. But because of the falling trend, he might not be able to sell at that value and might default the final repayment.
- The balloon payments are sometimes roll over at the end of its tenure into a new loan so that the borrower can close the old loan by paying with the amount received from the new loan. This system is called two-step mortgages. However, this reset process is not automatic. It depends on several factors like the past trend of paying installment, lender & borrower consensus, etc.
- The balloon payment will come near about twice of the amount of loan’s last payment.
The balloon loan might look attractive with lesser initial payment but creates a huge obligation at the end. If the fund is not managed efficiently one will be in big trouble for paying the final payment. The borrower has to check with his needs whether balloon loan is right as per his needs or not. One who lacks planning and management is not suggested to opt for this loan.
At the same time, the lender is supposed to deeply investigate the borrower’s ability to repay which is also termed as ATR. They must see their probable cash flows and their future commitments which will help them in judging their ability to repay the huge amount at the end.
This has been a guide to what are Balloon Payments and its definition. Here we discuss the example of Balloon Payment calculation along its Advantages and Disadvantages. You can learn more about Corporate Finance from the following articles –