It is not uncommon for individuals to take out loans when buying a new home. These loans make it possible to make the dream of owning a home come true. However, like all loans, even home loans, known as mortgages, are associated with different loans that help make it all possible.
One of these loans is a balloon loan.
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What is a Balloon Loan?
A balloon loan is a kind of loan that is not fully amortized over the duration of its term. And since it does not amortize, balloon loans require a balloon payment.
What is a Balloon Payment Loan?
A balloon payment is the final payment to repay the remaining principal balance at the end of the loan term.
Balloon loans are usually attractive to short-term borrowers because of their low interest rate feature. However, balloon loans do pose some refinancing risks as it is possible for the loan to reset at a higher interest rate.
Mortgages are more commonly associated with balloon payment loans. They typically have short terms that range from five to seven years. However, the monthly payments that are set up through this short term do not usually cover the entire loan payment. Instead, these monthly payments are still calculated on the basis of a traditional 30-year mortgage.
However, the payment structure for a balloon loan differs heavily from a traditional loan. At the end of the short term, the borrower, after paying off only a fraction of the principal balance, has to repay the remaining balance all at once. At this point, the borrower may be forced to sell the home in order to cover the balloon payment or take out a new loan leading to refinancing the mortgage. Alternatively, the borrower may also choose to make this payment in cash.
Moreover, some balloon loans have the option for a reset at the end of the short term. This allows the borrower to rest the interest rates based on the current ones and a recalculation of the amortization schedule which is based on a new term. However, in the case that the balloon loan does not have this reset option, the borrower is expected to pay the balloon payment or choose to refinance the loan before the original term ends.
A balloon loan could make sense if the interest rates are very high and the borrower is not planning on being at the location he is buying for long. However, this comes with a high risk when the term of the loan is complete. Moreover, if the interest rates are low and you expect them to rise, they will be considered as high when the borrower decides to refinance.
Is a Balloon Loan a Good Idea?
Before deciding whether or not a balloon loan is the right fit for you, you should look at the pros and cons of having a balloon loan.
Balloon loans can prove to be quite beneficial for buyers. For example:
- Borrowers are allowed to borrow more with the help of lower monthly payments than a traditional amortized loan would have since very little of the principal is being repaid.
- Borrowers not feeling the full impact of high interests since the payment is reduced because of the limited pay down of principal.
- Borrowers would also not have to commit to decades of paying a high interest rate since the typical term length of a balloon loan is five to seven years. After this, the borrower can refinance at a lower interest rate.
However, having a loan that requires you to pay a giant balloon payment at the end comes with its share of clear disadvantages as well.
- The borrower can end up defaulting on the loan if they fail to convince their current lender to finance the balloon payment, consequently failing to raise the funds to pay off the principal balance.
- If the borrower is unable to sell the property for a high enough price to pay off the balloon payment because of the fallen property values. This can lead to the borrower defaulting on the loan.
- The borrower is able to refinance the loan successfully but at a higher interest rate which ends up increasing the amount paid in monthly payments. This will especially be the case if the new loan is an amortized loan and includes paying off the amount of principal.
A balloon loan also tricks individuals by the smallness of the original interest-only monthly payment until they borrow more money than they can afford to borrow, earning them a one way ticket to financial ruin.
How to Calculate Balloon Payment?
You can either use a balloon loan calculator that is easily available online or perform the balloon loan payment calculations yourself.
Instead of one balloon payment formula, there are two ways you can go about the calculations.
- Use a balloon payment to calculate constant payment.
- Use a constant payment to calculate balloon payment.
Deciding which method to go for depends on how certain your cash flow is. For example, if you are uncertain about the short-term, the second method can be used to determine the balloon payment amount based on the knowledge of payments.
Balloon Payment Example:
Let’s suppose a person takes out a mortgage loan of $200,000 within a seven year term. Assuming the interest rate is at 4.5%, the monthly payment for the term, in this case seven years, will be $1,013. And by this account, the balloon payment owed by them at the end of the seven year term will be $175,066.
Balloon Payment vs. Bullet Payment
Balloon payments are often confused as bullet payments as well. This is not because of their similar names but because they both have similar jobs as well.
We know that a balloon payment is a large payment paid at the end of a balloon loan. This balloon loan can be a mortgage, commercial loan or other types of amortized loans.
Whereas, a bullet payment, also known as bullet repayment, is a lump sum payment made up for the entirety of an outstanding loan amount. It can also be paid as a single payment of principal on a loan. These types of loans have more use in the mortgage and business loan world in order to reduce monthly payments during the loan terms.
So, as we can see, the two types of payments are not different. They serve the same purpose and perform the same jobs. In fact, in banking and real estate, bullet payments are also referred to as balloon loans.
Now that you know what is a balloon payment loan, you know it is not as fun as the name sounds. There is more risk attached with higher interest rates and you should be careful when getting it as there is a risk of you being unable to pay the balloon payment and having to sell the house. This would be difficult on its own as selling a property that you still owe money on is not an easy task. And if you choose not to sell then you would have to refinance and end up stretching out the loan out for a few more years which will leave you upside-down, owing more than your property is even worth.