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 a risk the loan may reset at a higher interest rate.
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, they may make the payment in cash.
[Important: Defaulting on a balloon loan will negatively impact the borrower's credit rating.]
Example of a Balloon Loan
Let's say a person takes out a $200,000 mortgage with a seven-year term and a 4.5% interest rate. Their monthly payment for seven years is $1,013. At the end of the seven-year term, they owe a $175,066 balloon payment.
Special Considerations for a 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.
If interest rates are very high and, say for a mortgage, the borrower isn't planning to be at that location for long, a balloon loan could make sense. But it comes with a very high risk when the loan term is up. What's more, if interest rates are low or are expected to rise, they may well be higher when the borrower needs to refinance.
Pros and Cons of Balloon Loans
For some buyers, a balloon loan has clear advantages.
- much lower monthly payments than a traditional amortized loan because very little of the principal is being repaid; this may permit an individual to borrow more than they otherwise could
- if interest rates are high, not feeling the full impact of them because the borrower is just repaying interest
- if interest rates are high, not committing to decades of paying at that rate; the term is probably five to seven years, after which the borrower gets to refinance, possibly at a lower interest rate.
But having a loan with a giant balloon payment of most or all of the principal also has clear disadvantages.
- defaulting on the loan if the borrower cannot convince their current lender or another entity to finance the balloon payment – and cannot raise the funds to pay off the principal balance
- if property values have fallen, being unable to sell the property at a high enough price to pay the balloon payment, and then defaulting on the loan
- being able to successfully refinance the balloon loan, but at a higher interest rate, driving up monthly payments (this will be even more true, if the new loan is amortized and includes paying off the principal)
There's also an underlying risk of opting for a balloon loan: It's easy to be fooled by the smallness of the original interest-only (or mostly) monthly payment into borrowing more money than an individual can comfortably afford to borrow. That is also a potential road to financial ruin.