What are Balloon Payments?
The balloon payment is a huge sum paid at the end of a loan tenure. Most balloon loans come with a short-term tenure; it could be a commercial loan, mortgage, or fully amortized loan. Also, the final installment is at least double the previous installments.
The final loan installment is referred to as a balloon payment because the amount is huge—inflated like a balloon. Only a part of the principal sum is paid off over the period—the outstanding balance is paid in a lump sum—at the end of the repayment period.
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Table of contents
Key Takeaways
- A balloon payment is the final installment of a mortgage loan—paid at the end of the loan period. The amount is huge, inflated like a balloon.
- Most such loans are short-term and are offered at low-interest rates (when compared to traditional loans).
- These loans are very common in commercial lending—borrowers need immediate cash—they can arrange the repayment in the immediate future.
Balloon Payment Explained
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A balloon payment is a huge sum paid at the end of a balloon loan tenure. Only a small part of the principal sum is amortizedAmortizedAmortization of Intangible Assets refers to the method by which the cost of the company's various intangible assets (such as trademarks, goodwill, and patents) is expensed over a specific time period. This time frame is typically the expected life of the asset.read more during the period of the loan. At the end of the tenure, a huge final payment is made.
Usually, these loans are repaid within a short period. Interests are paid regularly, and final repayment is made for the outstanding principal. But it is more common among commercial lenders. Some homeowners struggle to make huge payments at once.
Due to the added risk, lenders thoroughly investigate borrowers’ ability to repay—ATR. Lenders look for probable cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more and future commitments. Sometimes, balloon payment defaults are rolled into a new loan. This way, the borrower closes the old loan using the newly loaned sum. This system is called two-step mortgages. Two-step mortgages are subject to several factors—credit history, lender consensus, borrower consensus, etc.
But, balloon mortgages don’t work when the housing market is failing. If borrowers take a housing loan projecting a larger resale value at the time of final payment, they may not recover the principal sum—loan defaultsLoan DefaultsDebt default refers to a situation in which a borrower fails to repay loans, causing the borrower's reputation to suffer. However, before the debt is declared a default, a notice is sent to the borrower stating the debt's position and the lender's intention to declare it a default in the event of non-repayment of the debt.read more.
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Calculator
The balloon payment calculator can be used to determine the final payment amount.
In regular mortgages, borrowers repay regular installments—including some principal amount and some interest amount. So, by the end of loan tenure, borrowers complete repayment of the entire loan and the interest.
However, for balloon loans and mortgages, monthly payments are very low. Therefore, only a small percentage of the principal amount is repaid. Thus, at the end of the tenure, the borrower is left with a huge sum—to clear due principal and interest.
Balloon Payment Example
Joseph takes a balloon mortgage of $417,000—to be repaid within two years. The interest rate is 2%, the first repayment date is 1st October 2015, and the monthly installment is $1,500 (inclusive of interest). Now, based on the given values, prepare Joseph’s payment schedule;
Solution:
Joseph’s payment amortization schedule is as follows:
In the above schedule, we can see that a huge payment of $398805.13 was made in August 2017. So, at the end (Sep 2017), liability becomes zero. Also, but for the last installment, only a small percentage of principal is repaid every month.
Advantages and Disadvantages
Following are the advantages:
- Compared to other loans, balloon mortgages have lower interest rates.
- Initial repayment installments are small.
- Compared to regular loans, the repayment tenure is usually shorter.
- Suitable for borrowers experiencing a cash crunch. These borrowers expect cash inflows in the immediate future.
- For the same borrower, lenders might sanction larger sums if they opt for a balloon loan.
The loan has its own limitations as well. Following are the disadvantages:
- Due to shorter loan tenure, non-payment may result in the sale of investments, property, or other fixed assetsFixed AssetsFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples.read more to cover outstanding liability.
- Non-repayment significantly lowers borrowers’ credit scores—potentially hindering future loans.
- It is difficult to refinance a balloon mortgage.
Frequently Asked Questions
Following are the different ways of shedding off the balloon payment:
– Use the surplus cash flow to pay off the debt and shrink the final payment.
– Be financially prepared for the large amount.
– Take another loan equivalent to the outstanding final payment—this way borrower can buy time to pay the amount gradually.
– If required, sell assets and investments to repay the outstanding debt.
Yes, the borrower can negotiate the loan amount, terms and conditions of repayment, and interest rates.
If a borrower clears all installments except the final payment, the lender proceeds with the loan default procedure (foreclosures). Alternatively, the lender can convert the large sum into a new loan—to be repaid gradually.
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