What Is a Balloon Payment?
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How Do Balloon Payments Work?
In mortgage lending, a loan with a balloon payment has lower monthly payments by design.
The idea is to make debt repayment easy for the borrower through low, fixed interest. In fact, mortgages with a balloon payment are cheaper than 15- and 30-year fixed-rate programs and adjustable-rate mortgages.
At the same time, the lender absorbs less risk by keeping the loan term’s length short or charging mostly interest every month.
In other words, a loan with a balloon payment either has a quick repayment schedule or has monthly payments that barely (or do not at all) reduce the principal balance.
For this reason, the total loan amount remains high when the loan matures. Afterward, the outstanding principal must be paid in full one way or another.
What Is an Example of a Balloon Payment?
Say a homebuyer takes out a five-year $260,000 mortgage with a 5% interest rate. Based on the standard 30-year amortization schedule, the monthly payment is $1,395.
After 60 months, the balloon payment is $238,804.80.
The difference between the original principal balance and outstanding loan amount is just $21,195.20, representing a -8.15% decrease.
Balloon Loan vs. Amortized Loan
Many people conflate the terms “balloon payment” and “balloon loans.”
The balloon payment is just the large one-time payment made for what is left of a non-standard loan’s principal balance at maturity. In contrast, a balloon loan is a loan designed to not fully amortize over the course of its life.
A balloon payment is also a component of bullet loans. It may appear in the contract of second mortgages as well.
Meanwhile, balloon loans have “balloon” in their name, but balloon payments are not exclusive to them. Like most fully amortizing loans, the balloon loan normally has monthly payments calculated using a 30-year amortization schedule. Therefore, the number of its installments stays the same, but its principal and interest may vary over the course of its life.
However, a balloon loan’s term is much shorter. Instead of 30 years, its full repayment is usually due in five or seven years. Considering that most of the loan payments apply toward the interest, only a small portion of the principal balance has been paid off when the final payment schedule arrives. This means a balloon loan’s balloon payment is much bigger.
On the other hand, a fully amortizing loan follows the standard amortization schedule. For example, if its calculation was based on a 30-year repayment period, it would mature by month 360. If it was supposed to amortize over 15 years, then it would be paid off by month 180.
With a fixed interest rate, the monthly payments of a fully amortizing loan remain unchanged from start to finish. After the first half of the loan term, the principal will predictably own a bigger slice of the monthly payments, and the interest’s share will shrink.
Balloon Payment vs. Bullet Payment
Balloon and bullet payments often mean the same thing. However, the term “bullet payment” is generally used in the context of bullet loans only. On the contrary, “balloon payment” can refer to balloon and bullet loans.
Balloon and bullet loan programs come with lower monthly payments. However, the bullet repayment schedule defers principal reduction and is longer than the term of balloon loans.
The bullet loan is often tied to interest-only monthly payments. In addition, some bullet loans give the borrower the option of not paying anything at all throughout the entirety of the term. The interest accumulates as stipulated by the contract, but everything must be paid upon maturity. In this case, the lump sum is the “bullet” payment.
The way a bullet loan is structured can make it expensive. That said, it can unburden the borrower of financially draining payments. This is why lenders offer bullet loans to raw land financing and real estate developers, who prefer not to pay anything while the development is ongoing and it has no means to be profitable.
Can a Balloon Loan Be Refinanced?
A balloon loan can be refinanced. Normally, borrowers who consider mortgages with a balloon payment do not intend to pay for it out of pocket.
Those planning to move elsewhere may sell their property ahead of the loan term’s end and use the proceeds of the sale to zero out the principal balance. Meanwhile, those staying put can refinance the mortgage before it matures.
Borrowers who intend to refinance their loan can apply for another short-term loan just to push the balloon payment’s due date back five or seven years. Replacing the balloon loan with a standard 15- or 30-year mortgage may also be an option.
Depending on refinance rates, a balloon loan refinance may cost the borrower more money in interest over the long term.
Is a Balloon Payment a Good Idea?
A balloon payment can be a good idea only if the borrower has a sure way to repay the principal balance.
The safest option is to use funds without the help of any third party. Unfortunately, this is difficult without having thousands of dollars lying around.
Another option is to repay the loan amount by selling the property or applying for a refi, which is inherently risky. If the borrower sells the property in a cold real estate market, where property prices are trending down instead of up, the borrower could be forced into a position where they have to sell the home at a loss.
On the other hand, there is also a risk for a mortgage refinance. The balloon loan is not designed to grow home equity quickly, so if the property does not significantly appreciate, its market value and the loan amount will more or less be close.
The problem is that home equity often makes or breaks refi applications. Most mortgage refinance lenders are reluctant to extend credit when the gap between the property’s value and the outstanding principal balance is too narrow.
Property depreciation can also sink a balloon loan underwater. With negative equity, refinance will practically be impossible.
Either way, there is great uncertainty in a balloon payment.
- A balloon payment is the lump sum paid to cover the outstanding principal balance that does not fully amortize over its life.
- “Balloon payment” can be used interchangeably with “balloon loan” and with “bullet payment,” although all three terms do not always carry the same meaning.
- Refinance is a popular way to avoid paying the balloon payment out of pocket, but it also carries risk, especially if the borrower’s equity on their property is too little.
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