Balloon Loan Payments: How Do They Work?
Some mortgage loans allow applicants to choose between a 15-year, 20-year, and 30-year term.
And when applying for a car loan, typical terms range between three and five years.
Regardless of the chosen term, most loans have fully amortizing payments, meaning the loan is paid in full at the end of the term.
This, however, isn’t the case with a balloon payment loan.
If you’re offered this financing option, make sure you understand how these loans work before signing on the dotted line.
How Do Balloon Payments Work?
To put it plainly, if you have a balloon payment, your loan doesn’t fully amortized over the term.
And as a result, your final loan payment is considerably more than preceding loan payments.
This payment might be more than double what you normally paid.
Depending on the balance at the end of the term, your final payment could be thousands of dollars.
Typically with a loan, monthly payments include repayment of both interest and principal.
If you have a balloon payment, though, your monthly payments will likely consist of interest-only payments. Therefore, you’ll owe all or most of the principal balance at the end of the term.
Since these loans don’t fully amortized, they’re more expensive on the back end. Your final loan payment must be enough to completely pay off the loan.
What Types of Loans Can Have Balloon Payments?
You might not hear about balloon payments as often as other types of loans.
Yet, balloon payments are more available than some people realize.
1. Commercial loans
Balloon payments are more common with short-term commercial real estate loans. Purchasing commercial real estate requires a large down payment, and your business must generate enough income to cover the mortgage on the property.
If you have limited cash flow, a commercial loan with a balloon payment can lower your initial monthly payments.
You’re able to build the company’s revenue, and then refinance the loan before it’s time to make the balloon payment.
The idea is to grow the business so that you can afford a larger monthly payment after refinancing the balance.
2. Auto loans
Some auto loans have a balloon payment, too. The purpose of getting a balloon payment is also to lower the initial monthly cost.
With an auto loan, the balloon loan term could range from three years to five years, with a lump sum due at the end of the term.
Some mortgage loans will also have a balloon payment due at the end of a short term. Similar to getting an auto loan or commercial loan, a balloon payment results in low initial monthly payments.
Let’s say you get a $250,000 mortgage with a seven-year term at an interest rate of 4%. You’ll make a monthly payment of $1,193 for seven years. At the end of the term, you’ll pay off the remaining balance of $216,342.
Since the average person isn't likely to have this type of cash lying around, balloon payment residential mortgages are usually an option for borrowers who only need a short-term loan—such as those who plan to move before their balloon payment is due.
What Is Needed to Qualify for a Balloon Payment Loan?
To get approved for a loan with a balloon payment, you’ll have to meet the same qualifications as getting any type of loan.
Lender requirements vary, but you’re expected to provide proof of adequate income and regular employment. Some lenders might even look at the long-term stability of your income for qualifying purposes. This helps gauge whether you’re likely to make the balloon payment when it’s due.
Even with these measures, there’s no way to guarantee a borrower’s ability to make their payment at the end of the term. Therefore, many lenders have to base approvals on a borrower’s current financial state.
Options If You Can’t Make a Balloon Payment
You might have every intention of making a balloon payment at the end of the term.
However, your financial situation can change before this time.
If you can’t make a balloon payment, your options include:
1. Sell the item
If you can’t pay the balloon payment on a mortgage, auto loan, or commercial loan, you can call your lender and ask for a payment extension.
But at this point, your only option might be to sell the item.
Use proceeds from the sale to pay off the remaining loan balance.
Many people go into a balloon payment loan with the intent of refinancing the loan once the balloon payment is due.
Refinancing is the process of getting a new loan to replace an existing loan.
So let’s say you have a three-year auto loan with a balloon payment. If you have a $10,000 balloon payment, there’s the option of refinancing the loan with your current lender or a new lender.
The new loan pays off the balloon payment, and then you’ll make monthly payments on the new loan. This also works with balloon payments on residential and commercial mortgages.
3. Walk away from the loan
As a last resort, you can also walk away or return an asset to a lender. This might be your only option if you don’t have cash to make a balloon payment, and you’re not in a position to refinance.
Most lenders will take back an asset and resell it to pay off the remaining balance.
Just know that this can have a significant negative impact on your credit score.
The lender will likely report the voluntary repossession or foreclosure to the credit bureaus. This can lower your credit score and make it difficult to get future loans.
Pros and Cons
While a balloon payment might make sense in some situations, make sure you understand the pros and cons of this decision.
- You’re able to save money. One attractive feature of a balloon payment is the ability to save money each month. Since you’ll make interest-only payments during the initial years, you can enjoy a low monthly payment. Plus, balloon payment loans can have lower rates than fixed-rate and adjustable-rate loans.
- You’re able to qualify for a bigger loan. And because balloon payments have smaller monthly payments and lower interest rates, it’ll be easier to qualify for a larger loan amount.
Cons of a Balloon Payment
- You might be unable to make the final payment. The biggest disadvantage of a balloon payment is the inability to make the final payment. This can result in repossession of an item and a damaged credit score.
- No guarantee that you’re able to refinance. If you get a balloon payment loan with the intent of refinancing at the end of the term, there’s no guarantee that you’ll qualify for a new loan. Refinancing involves meeting a lender’s income, credit, and employment requirements. If you can’t refinance, and if you’re unable to make the balloon payment, there’s the risk of losing the asset. Keep in mind, too, that depreciation can affect your ability to refinance or sell an asset. If a car loses too much value or the housing market crashes, you could end up owing more than the property’s worth.
Alternatives to a Balloon Payment
To keep your monthly payment as low as possible, ask your lender about longer loan terms.
Although a 30-year mortgage is typical, there’s a lesser known option called a 40-year mortgage.
This term isn’t offered by every lender. But when it is an option, you can receive a much lower monthly payment. And the good news is that the loan fully amortizes over 40 years.
There’s also the option of an adjustable-rate loan.
These mortgages start off with rates lower than a fixed-rate mortgage.
Just know that adjustable-rate mortgages reset after a period of time, in which case your mortgage rate could increase, decrease, or remain the same.
Adjustable-rates are usually an option for borrowers who plan to move before their interest rate resets.
If you’re shopping for an auto loan, six-year terms are also becoming more popular.
An extra year of payments can help lower your monthly payment.
Be mindful, though, when you choose a longer loan term, you end up paying more in interest.
Is a Balloon Payment Right for You?
Only you can decide whether a balloon payment loan is the right choice for you.
At present, these loans might be attractive.
But it’s important that you consider the long-term financial effects.
There’s a chance that you won’t be able to afford the final balloon payment, and there’s no guarantee that you’ll be able to refinance the loan.
If you decide on a loan with a balloon payment, only do so if you’re confident in your ability to pay off the loan completely at the end of the term.
Or, if you plan on selling the asset because you’re required to make the balloon payment.