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 a risk the loan may reset at a higher interest rate.
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.
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.
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.