What is a Balloon Payment?

What is a Balloon Payment?
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If you do an online search for "balloon payment," you'll see dozens of articles describing the advantages and disadvantages of a balloon payment loan. The principal advantage is a lower loan rate, usually somewhere between a half-point and a full point lower than the equivalent 30-year fixed rate loan. The disadvantage is that if you can't refinance at the end of the balloon loan period, you could default and lose your house – and you have no way of knowing what the lending environment will be like five to seven years in the future. In 2008, balloon payment mortgage defaults were one of the principal contributors to the financial unwinding that became "the Great Recession."

What Is a Balloon Payment Loan?

A balloon payment loan has a fixed term, a common feature of almost all mortgage loans. But unlike other mortgage loans, which are fully paid at the end of the loan term, a balloon payment loan is not. Instead, it has an amortization schedule (basically a table showing the number of payments necessary to pay off the loan) for a much longer-term loan – a 30-year mortgage loan, for example – but a loan term that expires after only a few years, often five to seven. When the loan term ends, the borrower has to close out the loan by paying the sizable balance remaining – the balloon payment. Failure to do so results in default and can lead to a foreclosure.

Balloon Payment vs. Bullet Payment

A more extreme form of a loan that requires a large payment at the end of its term is a loan with a bullet repayment. With a bullet payment loan, you pay nothing at all on the loan principal during its term; your payments are for interest only. At the end of the loan term, you have an obligation to pay the entire principal amount due, i. e., the full purchase price of the house.

Note that there is some disagreement about the meaning of a "bullet loan." An interest-only loan with a balloon payment at the end is the more common meaning of the term. However, "bullet loan" is sometimes used to describe any loan with a balloon payment, including loans with longer term amortization schedules than the loan's contractual length.

Balloon Payment Formula and Examples

Balloon loans are uncommon for residential mortgages and are more often available for commercial real estate. The balloon payment formula is quite simple. The loan has a long-term amortization schedule and a short-term maturity. In general, balloon payment mortgages come with lower fixed interest rates than fixed-rate loans with amortization schedules matching their maturities. The rate advantage can be as much as a full point lower than a normal 30-year fixed rate loan, although it's usually somewhat less. The rate advantage is similar to that of a 5/1 ARM, (the usual loan industry acronym for an Adjustable Rate Mortgage with a fixed rate for 5 years). After five years, a 5/1 ARM becomes an adjustable rate loan with a yearly adjustment.

On May 18, 2018, Quicken Loans, one of the largest U.S. mortgage providers, advertised the following residential loan rates:

  • 30-year fixed: 4.625 percent
  • 15-year fixed: 4.25 percent
  • 5-year ARM: 3.99 percent
  • 7-year ARM: 4.125 percent

Quicken doesn't offer a balloon payment residential loan, but a survey of commercial rates by other lenders shows that rates for commercial 7-year balloon payment loans are within a few hundredths of a point of 5-year ARM rates.

An Alternative to a Balloon Payment Auto Loan

Balloon payment auto loans offer similar advantages and disadvantages. Few lenders offer them, however, and while several auto finance websites warn against them, an extensive online search for a lender currently offering such loans didn't return even one.

If you need lower monthly payments to get the car you want – the single advantage of a balloon payment auto loan – consider an auto lease instead, which offers the same advantage with less risk.

If, for instance, you buy a new car for $25,000, make no down payment and pay it off in 3 years at an interest rate of 4 percent, your monthly payments (exclusive of fees, taxes and license) will be $739.

If you lease the car for the same period and assuming that after three years its anticipated residual value is 54 percent of the initial $25,000, which is about average, your lease payments will be only $399. This is approximately the same payment you would have with a balloon payment auto loan. Both the lease and the balloon payment loan calculate the monthly payment based on the residual value of your car at the end of the contract.

However, your lease options are better than they would be with the balloon payment loan. At the end of the lease, you can simply turn in the car; the contract expires and you have no further obligation. If you lease and decide to keep the car at the end of the lease period, you have the option of refinancing, but without the obligation to do so. If you can't find a lender for a refi, you can simply let the car go without affecting your credit.

With a balloon payment loan though, you're obligated to pay the residual value. If you have trouble refinancing to pay off the balloon, the car could be repossessed, leaving you with a significant negative entry on your credit report.

Pros and Cons of Balloon Payment Loans

Balloon payment mortgage loans have lower interest rates than 30-year fixed rate loans and, generally, lower rates than even 15-year fixed rate loans. Consequently, monthly payments are lower.

Balloon payment auto loans have lower monthly payments than fully amortized car loans for the same repayment period. Loan payments may be lower by nearly half.

However, balloon payment loans, whether for autos or houses, introduce several uncertainties and consequent risks. If, for instance, you were trying to find a new lender for a balloon payment loan coming due in early 2009 in the midst of the Great Recession, you might not have had success. The house might have been repoed and your credit score would have declined by hundreds of points.

At other times, the loan rates could climb during the five to seven years following your signing of the balloon payment loan. The higher interest rate may require payments even higher than if you'd originally taken out a 30-year fixed mortgage in the first place. The worst-case scenario could be that you wouldn't qualify for a loan with payments that high and, again, you could lose the house.