Whether you're considering a loan for a mortgage, car, or business, understanding what a balloon loan is and how this type of financing works is important. Unlike traditional loans, balloon loans have smaller payments upfront, with a large lump sum due at the end. This setup can be a good fit for some people—but are you one of them?
“While the lower initial costs seem appealing, balloon loans aren’t suitable for every small business and come with the very real risk of default if revenues don’t increase enough or refinancing isn’t possible,” says John F. Pace, CPA and tax manager for Pace & Associates CPAs. “As with any loan, it’s critical to understand the terms and your ability to repay before signing.”
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Balloon loan definition
So, what are balloon loans? They're a type of loan where the borrower regularly makes typically lower payments for a certain period—less than what would be required for a fully amortized loan (where each loan payment is the same amount for the duration of the repayment period). After this period, a large final payment, known as the “balloon payment,” is due. This balloon payment covers the remaining balance of the loan and is often much larger than the earlier payments.
Balloon loans are commonly used in various sectors, including real estate, automotive, and business financing. They are particularly appealing to borrowers who expect to have a large sum of money available by the time the balloon payment is due.
“The lower initial costs free up cash flow for operations or expansion,” Pace says. For example, say a restaurant opened using a 5-year balloon loan. Within 18 months, their revenue triples. Now the business might have enough money for the balloon payment at the end of their term.
(What does a 5-year balloon mean? It's when the borrower makes regular monthly payments for five years. You’ll see more details on how it works below.)
How does a balloon loan work?
Balloon loans are structured differently from traditional loans. Let’s break it down.
Initial loan period
This is the period during which the borrower makes regular monthly payments. These payments are typically lower than those of a fully amortized loan because they may only cover interest or include a small portion of the principal.
Let’s say you take out a 7-year balloon loan mortgage for $200,000 at an interest rate of 4%. During the 7-year loan term, you make monthly payments based on a 30-year amortization schedule—you’re essentially cramming a 30-year mortgage into 7 years. As a result, your payments will be slightly lower than they would with a full 30-year fixed-rate mortgage.
So in this example, the monthly payment (principal + interest) for seven years would be approximately $954.83, totaling $80,988.92. And after seven years of payments, the remaining balance (balloon payment) would be approximately $175,306.44.
In contrast, with a 30-year fixed-rate mortgage, you’d pay $961 monthly, for 30 years.
Balloon loans can vary in term length, but they typically range from five to seven years for mortgages. For auto or business loans, the terms might be shorter.
Balloon payment due
At the end of the loan term, the balloon payment is due. This payment is the full remaining balance of the loan, which can be a significant amount.
In the example above, after seven years of making lower monthly payments, the remaining balance on your $200,000 mortgage might be around $175,000. This $175,000 is the balloon payment that you are now required to pay in full.
If you plan ahead and have a strategy for handling the balloon payment—such as saving up, refinancing, or selling the property—a balloon loan can be a viable option. However, without a plan, the large balloon payment can pose significant financial risk.
The pros and cons of balloon loans
Are balloon payments a good idea? What are the drawbacks of a balloon loan? This type of financing comes with both benefits and risks that borrowers should carefully consider.
Pros:
- Lower monthly payments during the initial period: This can make it easier to manage your finances or afford a larger loan amount than you might otherwise qualify for. This is more common in loans with shorter amortization schedules or loans with interest-only payments during the initial term.
- Flexibility: Especially if you expect a significant influx of cash before the balloon payment is due. This might be from selling an asset, receiving a bonus, or expecting a higher income.
- Short-term financing: If you only need financing for a short period, a balloon loan can be an efficient way to borrow money without locking yourself into long-term payments.
Vincent Cerniglia, CEO of Noreast Capital Corporation, which provides nationwide finance and leasing solutions to the equipment industry, shares an example to illustrate these benefits in action.
“I advised a startup client who couldn’t afford high initial payments but anticipated major growth in three years,” he says. “The balloon loan kept doors open until new investors paid off the balance.” In that case, the balloon loan was the right loan type for that client.
Cons:
- Risk of a large final payment: If you're unable to make this big payment when it comes due, you could face serious financial consequences, including foreclosure or repossession of collateral. So there’s your answer to the question, “Why is a balloon payment risky?”
- Uncertainty of refinancing: Many borrowers plan to refinance the loan before the balloon payment is due. However, refinancing is never guaranteed and could be more difficult if your financial situation or market conditions change.
- Potential for higher long-term costs: If you end up refinancing or taking out another loan to cover the balloon payment, you might end up paying more in interest and fees over the long term compared to a traditional loan.
Options for handling the balloon payment
Let’s dive into how to beat a balloon payment—you have several options for dealing with it.
- Pay the balloon payment in full: If you have the funds available, you can pay off the remaining balance.
- Refinance the loan: Can you refinance a balloon loan? Yes: if you anticipate difficulty in making the balloon payment, a refinance balloon payment can allow you to convert the remaining balance into a new loan with more manageable quotas.
- Sell the asset: If the loan is tied to an asset like a home, you could sell the property to cover the balloon payment.
- Ask for some flexibility: Sometimes, some lenders might be willing to modify the loan terms, such as extending the loan period or adjusting the payment schedule.
- Make advanced payments: You can also pay off a balloon loan early; just be sure to check the terms of your loan agreement for any prepayment penalties. If there are penalties, you’ll need to weigh those costs against the benefits of early repayment.
Cerniglia offers another example of a client who took out a balloon loan. “A medical practice had high initial debt but revenue potential,” he says. “A few years of lower payments, then a refinance at lower rates eliminated the balloon. This shows using a balloon strategically based on future prospects if you have a sound plan to address the final payment.”
If you’re unsure about how to handle the balloon payment, consult with a financial advisor or loan officer for guidance.
Who benefits from a balloon loan?
Balloon loans are not suitable for everyone, but they can be beneficial for certain types of borrowers:
- Short-term borrowers: If you need financing for a short period and are confident you can pay off the loan before the balloon payment is due, a balloon loan might be a good fit.
- Someone anticipating a windfall: Borrowers who expect a significant sum of money in the future, such as from an inheritance, bonus, or sale of an asset, might find a balloon loan appealing.
- Investors: Real estate investors sometimes use balloon loans to purchase properties that they plan to sell before the balloon payment is due.
- Businesses: Companies that expect future growth or revenue increases might use balloon loans to manage cash flow while waiting for their income to catch up.
Last things to consider before signing
Before deciding on whether to take a balloon loan or not, it's essential to weigh your financial stability: Are you confident in your ability to handle the balloon payment when it comes due? Consider your income, assets, and any expected changes in your financial situation.
Also, have a clear plan for how you will make the balloon payment. This might involve saving aggressively, selling assets, or arranging for refinancing.
Lastly, carefully review the terms of the balloon loan, including the interest rate, the length of the loan, and any penalties for early repayment.