What Is a Balloon Maturity?
Balloon maturity refers to a scenario when the final payment to repay a debt is significantly larger than the previous payments.
The most common usage of this term is bond issues. Issuing bonds and planning for a balloon maturity can be risky for an issuer. For example, if in one year a bank issues 500 bonds that will mature in 10 years, the bank must be confident it will be able to cover the principal of all 500 bonds when they mature and are due. Likewise, it must also be able to meet all of the coupon payments for the duration of those 10 years.
- Balloon maturity refers to when the final payment to repay a debt is significantly larger than the previous payments.
- A bond issuer might favor a balloon payment upon maturity if it anticipates income being more significant toward the end of the bond duration.
- Though the term "balloon maturity" comes from bond issues, it is now commonly used to refer to large final payments to repay mortgages, often called a "balloon mortgage," commercial loans, and other types of debts.
What are Balloon Payments?
Understanding Balloon Maturity
The term "balloon maturity" comes explicitly from bond issues. Bond issuers may avoid balloon maturity. For example, an issuer can decide to issue serial bonds. Serial bonds are paid off periodically rather than at one final maturity date. These bonds mature gradually over a period of years and are used to finance large projects which span several years to complete.
For example, an issuer may choose to release 500 bonds which mature gradually, with payments due annually for five years. In this way, the issuer can prevent a balloon maturity because the bonds will not require the issuer to turn over one enormous lump sum payment when the bonds mature. However, balloon maturity has also come to refer to large final payments to repay mortgages, commercial loans, and other types of debts.
While balloon maturity may be associated with bonds, the term is frequently used in the real estate industry as a particular kind of mortgage.
For example, if the structure of a mortgage has a balloon payment at the end, it will have several smaller payments followed by one large balloon payment. The increased balloon payment is because the debt has not been amortized during all of the smaller installments. Amortization creates a schedule of regular payments that include both interest and principal.
Generally, earlier payments will mostly cover interest and only slightly pay down the principal. However, closer to the end of the loan term, most of the payment goes to the principal. This repayment structure can be attractive if a new business needs a loan but does not currently earn enough profit to make full payment on that loan each month. However, the company may be confident in 10 or 15 years, when the loan term ends, it will have grown exponentially and been able to meet the balloon payment.
An individual may opt for a home mortgage with a balloon payment at the end, often referred to as "balloon mortgages." The buyer may choose to do this because their income is currently low, but they anticipate coming into a large sum of money much later. For example, they may expect a large inheritance or the sale of another property in the future. If the borrower cannot make the final balloon payment, they may refinance their mortgage or even sell their house to settle the balance on the debt.