Most borrowers are used to more traditional, fully amortizing loans, where the loan is paid in full at the end of the loan term. This typically occurs with auto loans, traditional mortgages, and student loans.
However, some loans require a large payment at the end of the loan term. This type of loan is called a balloon payment loan. In this article, we'll discuss the pros and cons of these loans, whom they could be right for, and some alternatives to consider.
What is a balloon payment?
Balloon payment loans differ from more traditional types of loans in an important way: When a borrower takes out a balloon payment loan, there is a predefined balance remaining at the end of the loan term. With these loans, the borrower typically either sells the asset before the balloon payment comes due, pays the balance in full, or refinances the loan to extend its term or swap it out with a different loan type.
Balloon loan payments can be interest-only or amortizing loans with either a fixed or variable interest rate. For loans that are amortizing, the amount of principal paid each month is less than a fully amortizing loan that leaves a zero balance at the end of the term. If a balloon payment loan does amortize, the amortization schedule pays down to the balloon payment amount, rather than to zero.
Leaving a balance remaining at the end of the term reduces the required monthly payment because less of the payment goes toward the principal. However, if a borrower hasn't planned appropriately, they could suffer payment shock when the balloon payment comes due.
In the chart below, we illustrate three loan amount options for a $500,000 loan at a 4% interest rate for 30 years. The first option is a traditional loan that is fully amortized. The second option is an interest-only loan with a large lump sum payment of $500,000 at the end, and the third option is partially amortized and adds the remaining balance of $100,000 to the final payment.
|Month||Traditional, fully amortized loan||Interest-only balloon loan||Partially amortized balloon loan|
The pros and cons of balloon payments
Pros of balloon payments
- Lower monthly payments: These loans might be advantageous to certain borrowers because the required monthly payment is generally less than a fully amortizing loan. For instance, investors often seek to minimize the amount of cash they put into an investment property.
- Reduced debt-to-Income (DTI) ratio: A lower loan payment could reduce your DTI ratio and might make it easier to get approved for a mortgage loan and qualify for other loans in the future.
- Gives borrower time to improve finances: This type of loan could give a borrower more time to increase income, grow assets, or improve credit to make the balloon payment or refinance to a traditional mortgage.
Cons of balloon payments
- Loan default could lead to foreclosure. Homeowners who are unable to make the balloon payment could have their property foreclosed by the lender, even if they've made every other payment on the loan.
- Timing of balloon payment could be impactful. If the balloon payment comes due at the wrong time, you could be forced to sell in a down market or refinance your mortgage when interest rates have increased.
- Balloon payments may have higher rates. Because the lender typically has to wait longer to be repaid their principal, they may view a balloon payment loan as riskier. As a result, this type of loan could come with a higher interest rate.
Who are balloon payments right for?
Balloon payment loans are not as common as they used to be, and there are risks associated with this type of loan, but they still have a place in the lending world for certain types of borrowers. You might want to look into how to get a loan with a balloon payment if you understand the risks and if:
1. You’ll have rapidly increasing income
Borrowers who can’t necessarily afford a balloon payment today but expect to increase their income significantly might want to consider this type of loan. Examples of this type of homebuyer could include doctors in residency, entrepreneurs at a startup expecting to go public, or professional athletes. Over time, these borrowers’ assets are likely to grow and the balloon will not be as significant in comparison, or their salary could allow them to refinance to another loan type.
2. You’re waiting for a financial windfall
Borrowers expecting to receive a financial windfall soon might also find a balloon mortgage payment appealing. If you're expecting a legal settlement, inheritance, or some other big-money event, it could make sense to keep your payments low in the short term and use the windfall as repayment for the loan.
3. You’re a commercial real estate investor
Commercial real estate loans often have a balloon component to them. These loans often amortize over a 25-year period, but the loan matures in 10 years. The shorter loan term could reduce the risk to the lender and requires the borrower to justify their creditworthiness regularly if they refinance into a new loan.
3 balloon payment alternatives to consider
Although balloon payment mortgages could be attractive for the right type of borrower, they are not without risks. Some borrowers might opt to seek other alternatives to have peace of mind without the huge obligation of a large balloon payment hanging over their heads for many years. If that’s the case for you, here are some alternatives to consider:
1. Fixed-rate mortgage
A fixed-rate home loan offers the same interest rate throughout the term of the loan. Although the rate and payment may be higher than some other loan options, these loans offer consistency and no unexpected interest rate adjustments or balloon payments. When interest rates are low, borrowers that opt for a fixed-rate mortgage might benefit by locking in reduced rates that could otherwise increase with a different loan product.
2. Adjustable-rate mortgage
An adjustable-rate mortgage (ARM) loan could be an attractive option when interest rates are declining or expected to be low for an extended period. With this type of loan, the interest rate is fixed for a set time of the overall loan period, then adjusts once the introductory period expires. Many 30-year ARMs offer a fixed rate for three to 10 years, then adjust annually afterward.
During that introductory period, the interest rate is often lower than the interest rate on a fixed-rate loan, which typically reduces the monthly payment. Lower payments might allow borrowers to be approved for a larger loan amount than what they’d get with a fixed-rate mortgage. However, interest rates can be unpredictable. There’s a risk they could rise dramatically over time and potentially make the monthly payments on an ARM loan unaffordable.
3. FHA loans
Federal Housing Administration (FHA) loans generally offer more flexible underwriting guidelines than traditional mortgages. Borrowers with credit scores in the 500 range might be approved for certain FHA loans. Depending on their credit score, a borrower might also be offered a down payment as low as 3.5% with a DTI ratio as high as 57%. These favorable terms make FHA loans an appealing option for those having trouble coming up with a large down payment, or those who have a lower score or too high of a DTI ratio for a traditional loan.
Are balloon payments a good idea?
Although a balloon payment loan is not a good option for many borrowers, it might make sense in the right situation. For some borrowers, these loans could be a good choice. However, before applying for a balloon payment loan, be honest with yourself about your ability to make the balloon payment or refinance the loan before the large payment is due. Also speak with a lender about your options. You might find that another type of loan could work better, depending on your situation.
How can you reduce a balloon payment?
One of the best ways to avoid the obligation of a balloon payment is to consider refinancing the loan. You might refinance into another balloon payment to extend your loan term, or choose a fully amortizing loan to eliminate the balloon payment altogether.
What types of loans have balloon payments?
Balloon payment loans are typically related to real estate. Although not as common as before the financial crisis of 2008, balloon payment mortgages are still available today. Real estate investors might use them for commercial mortgages or fix-and-flip investments, for example. Some home equity lines of credit also come with balloon loans that require the HELOC to be paid off or start amortizing at the end of the draw period.
The bottom line
Balloon payment loans could potentially be a useful tool for the right borrower. They allow borrowers to enjoy a lower payment throughout the loan term with the promise of paying a large sum in the future. However, it’s important to keep in mind that lenders and borrowers take on a substantial risk with this type of loan, so the rates tend to be higher than what you’d see with traditional loans.
For borrowers who want to reduce this risk, there are alternatives available, such as an FHA loan, fixed-rate mortgage, or ARM. If you are shopping around for a home loan, check out our picks for the best mortgage lenders.
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