What is a 'Balloon Loan'

A balloon loan is a type of loan that does not fully amortize over its term. Since it is not fully amortized, a balloon payment is required at the end of the term to repay the remaining principal balance of the loan. Balloon loans can be attractive to short-term borrowers because they typically carry lower interest rates than loans with longer terms; however, the borrower must be aware of refinancing risks as there's there's a risk the loan may reset at a higher interest rate.

BREAKING DOWN 'Balloon Loan'

Some balloon loans, such as a five-year balloon mortgage, have a reset option at the end of the five-year term that allows for a resetting of the interest rate, based on current interest rates, and a recalculation of the amortization schedule based on a new term. If a balloon loan does not have a reset option, the lender expects the borrower to pay the balloon payment or refinance the loan before the end of the original term.

How Do Balloon Payments Work?

Mortgages are the loans most commonly associated with balloon payments. Balloon mortgages typically have short terms ranging from five to seven years. However, the monthly payments through this short term are not set up to cover the entire loan repayment. Instead, the monthly payments are calculated as if the loan is a traditional 30-year mortgage. (See the mortgage calculator below for an example of how a conventional fixed-rate mortgage is calculated).

 

That said, the payment structure for a balloon loan is very different from a traditional loan. Here's why. At the end of the five to seven-year term, the borrower has paid off only a fraction of the principal balance, and the rest is due all at once. At that point, the borrower may sell the home to cover the balloon payment or take out a new loan to cover the payment, effectively refinancing the mortgage. Alternatively, he may make the payment in cash.

For example, imagine a person takes out a $200,000 mortgage with a seven-year term and a 4.5% interest rate. His monthly payment for seven years is $1,013, and at the end of the seven-year term, he owes a $175,066 balloon payment.

What Are the Advantages and Disadvantages of Balloon Loans?

The advantage of a balloon loan is it gives the borrower access to a flexible interest rate. Rather than committing to a set rate for a 30-year term, the borrower gets to enjoy one rate for five to seven years and then gets to refinance, possibly at a lower interest rate.

However, if the borrower cannot convince his current lender or another entity to finance the balloon payment, he may default on the loan. Similarly, if the borrower decides to pay the balloon payment by selling his property and its value has fallen, he is also likely to default on the loan. In some cases, the borrower may be able to successfully refinance the balloon payment, but his interest rate may be higher, driving up his monthly payments.

RELATED TERMS
  1. Balloon Payment

    An oversized payment due at the end of a mortgage, commercial ...
  2. Bullet Loan

    Any loan that requires a balloon payment at the end of the term ...
  3. Balloon Mortgage

    A type of short-term mortgage. Balloon mortgages require borrowers ...
  4. Balloon Maturity

    1. A repayment schedule for a bond issue where a large number ...
  5. Non-Amortizing Loan

    A type of loan in which payments on the principal are not made, ...
  6. Interest Due

    The portion of a current mortgage payment that is comprised of ...
Related Articles
  1. Personal Finance

    Understanding Term Loans

    A loan from a bank for a specific amount that has a specified repayment schedule and a floating interest rate.
  2. Personal Finance

    Top 10 Common Mortgage Scams To Avoid

    How do you know which companies to avoid? Look for these telltale signs.
  3. Investing

    Financial Institutions: Stretched Too Thin?

    Find out how to evaluate a firm's loan portfolio to determine its financial health.
  4. Personal Finance

    Reduce Interest With An All-In-One Mortgage

    "Offset" mortgages combine a checking account, home-equity loan and mortgage into one account.
  5. Investing

    Commercial Real Estate Loans

    Obtaining a commercial real estate loan is quite different from borrowing for residential real estate. Here's what to expect and how to get what you need.
  6. Personal Finance

    Mortgage Amortization Strategies

    Should you get a 30-year mortgage? A 15-year one? Ways to decide which mortgage is the best fit.
  7. Personal Finance

    Understanding the Mortgage Payment Structure

    We explain the calculation and payment process as well as the amortization schedule of home loans.
  8. Personal Finance

    Top 6 Mortgage Mistakes

    These common errors could end in foreclosure.
  9. Personal Finance

    How to Get a No Down Payment Mortgage

    There are only a few ways to get out of making a down payment, but the requirements are strict.
RELATED FAQS
  1. Which is better, a fixed or variable rate loan?

    A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest ... Read Answer >>
  2. What is PMI, and does everyone need to pay it?

    Also known as "Primary Mortgage Insurance," PMI is the lenders (banks) protection in the event that you default on your primary ... Read Answer >>
Trading Center