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 with 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 are due. Likewise, it must also be able to meet all of the coupon payments for the duration of those ten years.
BREAKING DOWN Balloon Maturity
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 maturation 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 when the bonds mature.
Balloon Maturity in Mortgages
The term balloon maturity comes explicitly from bond issues. However, it has also come to refer to large final payments to repay mortgages, commercial loans and other types of debts. 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 structure of repayment can be attractive if a new business needs a loan but does not currently earn enough profit to make a 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 also opt for a home mortgage with a balloon payment at the end. They 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 be able to refinance their mortgage or even sell their house to settle the balance on the debt.