What is a 'Balloon Payment'
A balloon payment is a large payment due at the end of a balloon loan, such as a mortgage, commercial loan or other amortized loan. A balloon loan typically features a relatively short term, and only a portion of the loan's principal balance is amortized over the term. At the end of the term, the remaining balance is due as a final repayment.
BREAKING DOWN 'Balloon Payment'The word balloon refers to the fact that the final payment is large and has ballooned in comparison to the other payments. Balloon payments tend to be at least double the amount of the loan's previous payments, but can be as high as hundreds of thousands of dollars. Balloon loans are more common in commercial than consumer lending.
Balloon Payments and Two-Step Mortgages
Balloon payments are often packaged into two-step mortgages. In this type of mortgage, the borrower pays a set interest rate for a certain number of years, and at the end of that term, the loan resets and the balloon payment rolls into a new or continuing amortized mortgage at the prevailing market rates. With some two-step mortgages, the reset process is not automatic. Instead, it depends on multiple factors, such as whether or not the borrower has made timely payments and whether or not his income has remained consistent. If the loan does not reset, the balloon payment is due.
Balloon Payments and Adjustable Rate Mortgages
An adjustable Rate Mortgages (ARM) is often confused with a balloon loan. With an ARM, the borrower receives an introductory rate for a set amount of time, often for a period ranging from one to five years. At that point, the interest rate resets, and it may reset periodically until the loan is fully repaid. However, unlike a balloon loan, an ARM adjusts automatically, and the borrower does not have to apply for a new loan or refinance the balloon payment.
How Borrowers Make Balloon Payments
The average homeowner typically cannot make a large balloon payment at the end of a mortgage, even if substantial principal payments are made over the life of the loan. Because of this, most homeowners and borrowers plan in advance to either refinance their mortgages near the balloon-payment dates, or simply sell their homes before the loans' maturity dates.
How the Housing Market Affects Balloon Payments
Balloon payments can be a big problem in a falling housing market. As house prices fall, the odds of homeowners having positive equity in their homes also drops, and they may not be able to sell their homes for the prices they anticipated. As a result, borrowers often have no choice but to default on the loans and enter foreclosure, regardless of their levels of household income.