What Is a Balloon Loan?
A balloon loan is a type of loan that does not fully amortize over its term. Since it is not fully amortized, a balloon payment is required at the end of the term to repay the remaining balance of the loan.
Balloon loans can be attractive to short-term borrowers because they typically carry lower interest rates than loans with longer terms. However, the borrower must be aware of refinancing risksas there's a possibility the loan may reset at a higher interest rate.
Key Takeaways
- A balloon loan is a short-term loan that does not fully amortize over its term.
- Payments are either interest-only or a mix of mainly interest and some principle for a set number of payments.
- The remainder of the loan is due at once in what's known as a balloon payment.
- Balloon loans are popular in construction and home flipping.
:max_bytes(150000):strip_icc()/balloonloan.asp-final-adc4ed58300e4c13a8497d3afd9fd46d.png "Balloon Loan: What It Is, How It Works, Example, and Pros & Cons (1)")
How a Balloon Loan Works
Mortgages are the loans most commonly associated with balloon payments. Balloon mortgages typically have short terms ranging from five to seven years. However, the monthly payments through this short term are not set up to cover the entire loan repayment. Instead, the monthly payments are calculated as if the loan is a traditional 30-year mortgage.
That said, the payment structure for a balloon loan is very different from a traditional loan. At the end of the five to seven-year term, the borrower has paid off only a fraction of the principal balance, and the rest is then due all at once. At that point, the borrower may sell the home to cover the balloon payment or take out a new loan to cover the payment, effectively refinancing the mortgage. Alternatively, they may make the payment in cash.
Defaulting on a balloon loan will negatively impact the borrower's credit rating.
Example of a Balloon Loan
Let's say a person takes out a $200,000 mortgage with a seven-year term and a 4.5% interest rate. Their monthly payment for seven years is $1,013. At the end of the seven-year term, they owe a $175,066 balloon payment.
Special Considerations for a Balloon Loan
Some balloon loans, such as a five-year balloon mortgage, have a reset option at the end of the five-year term that allows for a resetting of the interest rate, based on current interest rates, and a recalculation of the amortization schedule, based on a new term. If a balloon loan does not have a reset option, the lender expects the borrower to pay the balloon payment or refinance the loan before the end of the original term.
If interest rates are very high and (in the case of a mortgage) the borrower doesn't plan to keep the home for long, a balloon loan could make sense. But it comes with high risk when the loan term is up. The borrower will need financial discipline to save enough money for the balloon payment. What's more, if interest rates are low or are expected to rise, they may well be higher when the borrower needs to refinance.
Pros and Cons of Balloon Loans
For some buyers, a balloon loan has clear advantages.
- Much lower monthly payments than a traditional amortized loan because very little of the principal is being repaid; this may permit an individual to borrow more than they otherwise could.
- Not feeling the full impact of high interest rates because, as noted above, the payment is reduced, given the limited pay down of principal.
- Not committing to decades of paying at a high interest rate; the terms are typically five to seven years, after which the borrower gets to refinance, possibly at a lower interest rate.
But having a loan with a giant balloon payment of most or all of the principal also has clear disadvantages.
- Defaulting on the loan if the borrower cannot convince their current lender or another entity to finance the balloon payment and cannot raise the funds to pay off the principal balance.
- Being unable to sell the property at a high enough price to pay the balloon payment, and then defaulting on the loan.
- Being able to successfully refinance the balloon loan but at a higher interest rate, driving up monthly payments (this will be even more true if the new loan is amortized and includes paying off the principal).
There's also an underlying risk of opting for a balloon loan. It's easy to be tricked by the small size of the original interest-only (or mostly) monthly payment into borrowing more money than an individual can comfortably afford to borrow. That is also a potential road to financial ruin.
What Industries Use Balloon Loans?
Balloon loans are popular in the construction industry and for home flippers. Contractors or real estate investors use the low initial payments to complete work on a project, hoping to sell it before the balloon payment comes due.
What Happens if You Can't Pay Your Balloon Payment?
Defaulting on your balloon payment is the same as defaulting on any loan—it can lead to foreclosure and repossession of property. Defaulting will ruin your credit rating, making it harder to borrow in the future.
Can You Refinance a Balloon Loan?
Yes. Many people plan to refinance a balloon loan before the balloon payment is due to take advantage of the more affordable initial interest-only period, hoping that interest rates will be more favorable later. This is risky, however—interest rates are volatile, and you may end up refinancing for a higher rate than if you had chosen a fixed-interest rate loan in the first place.
The Bottom Line
Balloon loans can offer flexibility in the initial loan period by providing a low payment. Still, borrowers should have a plan to pay the remaining balance or refinance before the payment comes due. These loans do have their place—for those who only need to borrow for a short time, they can offer significant savings. Be realistic about your loan needs before borrowing.
