Balloon Payments: Examples, and Pros/Cons
You might be familiar with traditional loan instalments that are distributed equally. Every installment amount will be almost the same. Besides traditional loan payments, borrowers also prefer balloon payments. These payments allow borrowers to pay small early installments, followed by large ones.
What is a Balloon Payment?
A balloon payment is the final due amount of a specialised loan that collects small early instalments. The loan is structured in a way that the borrower pays small installments. However, the highest payment is made in the last installment, called the balloon payment. The initial loan payments might all be interest due on the loan. The last one is mostly the pending principal loan amount. This type of specialised loan is called a balloon loan.
This structure was widely popular for mortgages before the 2010s. However, itcan can now be seen in various sectors, including business and automobile loans. Borrowers often prefer balloon loans, as they owe small amounts in the first few installments. However, it also means that borrowers owe a significant amount, which will be paid in the last instalment. It is similar to blowing air in a balloon, as it keeps getting bigger!
How does a Balloon Payment Work?
Now that you understand the balloon payment meaning, let us discuss how it works. These payments are compatible with loans having a specialised structure. These loans are structured in a way that borrowers pay small installments for a certain period. The instalments are relatively small, which attracts borrowers. However, the main payment or the principal amount is paid towards the end of the loan tenure. Also, the last payment is significantly larger than other installments.
The balloon payment comes after the initial payment tenure. The initial payment tenure consists of small payments, which are mostly the interest on the loan. Once the initial payment tenure ends, the borrower makes these payments. Also, it is mostly the principal due amount.
When is a Balloon Payment Due?
As discussed above, the balloon payment is usually the last instalment of the loan. It is a lump sum paid towards the loan tenure’s end. Once this payment is made, the loan is closed. These payments mostly consist of the principal loan amount. It happens because the interest payment has been made in earlier installments.
Let us say you took a balloon loan with a repayment tenure of two years. In such a case, the balloon payment will arrive at the end of the repayment tenure, i.e. two years. It is crucial to note that the payment will be significantly higher than other instalments. You will pay a lump sum to the creditor in the last instalment as per the balloon loan terms.
Examples
Now that you have understood the concept, let us discuss some examples.
-
Mortgages : Mortgages are often structured as balloon loans. Individuals with minimal earnings can afford a house with the help of balloon loans. These mortgages ask borrowers to pay significantly small amounts in the initial installments. However, the borrower must pay a significant amount to close the mortgage at the end of the loan tenure. It gives debtors a breather for the first few installments.
-
Auto Loans : Many auto loans consist of this type of payment structure. The initial payments are small, followed by a large payment towards the end of the loan tenure.
-
Business Loans : Businesses are also allowed to apply for balloon loans. Businesses have to pay small early instalments, thus giving them the time to grow. However, they must close the loan by making the last payment towards the end of the repayment tenure. Again, the balloon payment will be significantly higher than other instalments of the business loan.
Options for Avoiding a Balloon Payment
Now that we have discussed balloon payment examples, let us understand how you can avoid it.
-
You may opt for loan refinancing by working with some other lender. Some other lenders might repurpose the loan and remove the necessity for a balloon payment.
-
Some borrowers might not have the required amount to make the last payment. You can sell the underlying asset to close the loan as a last resort.
-
Borrowers can pay some portion of the principal amount before starting the loan tenure. Some portion of the principal amount can be paid with the first few installments. However, the lender might charge you with prepayment fees.
-
Contact your lender and try to work out different terms and conditions. Sometimes, lenders offer extensions to borrowers for the last payment.
Advantages of Balloon Payments
Here are the pros you must know:
-
A balloon loan has small initial installments. It reduces the burden on the borrower and allows them to maintain their financial position. The initial installments of a balloon loan are usually lower than that of traditional amortised loans.
-
Borrowers have the time to increase their earnings with a balloon loan. Since most individuals start with low salaries, balloon loans will demand small installments. When the final payment finally arrives, the borrower’s earnings might have increased substantially.
-
The transaction or administrative fees for balloon loans are usually less than that of traditional loans. This is because the underwriting costs associated with balloon loans are usually low.
-
Many individuals rely on balloon loans for strategic advantages. For instance, a real estate seller can purchase a new house with the help of a balloon loan. They can remodel the house while paying small initial installments. They might sell the house to a customer before the balloon payment arrives.
Disadvantages Of Balloon Payments
You must be aware of the downsides of balloon payments, which are as follows:
-
The final payment might be significantly larger than other loan instalments. Sometimes, it is even 50% of the entire loan amount. The borrower might feel the pressure of paying a lump sum amount at once towards the end of the loan tenure.
-
Some borrowers might be interested in foreclosing their balloon loans. However, they might have to pay foreclosure or prepayment charges.
-
Individuals using balloon loans for business or strategic purposes might sometimes face issues. For instance, home flippers might get stuck with balloon loans when they cannot find potential buyers.
-
Some borrowers might want to refinance their balloon loans and convert them into traditional amortised loans. However, finding a lender willing to refinance an existing balloon loan might be challenging.
Conclusion
Balloon loans are popular for mortgages, business loans, and auto loans. These loans allow the borrower to pay small initial installments, mostly interest on the loan. However, the last installment is significantly larger and is called the balloon payment. The loan is closed after the borrower makes the last payment. In some cases, these payment might be 50% (or more) of the entire loan amount. Check out the differences between traditional and balloon loans now!
You May Like Also:-
