What Is a Balloon Payment?
A balloon payment is a large payment that comes due as the final payment of a balloon loan. Be sure to understand the risks before you agree to a balloon loan.
February 23, 2022
Loans allow you to purchase things that you can’t afford to buy outright — vehicles, homes and businesses, for example.
In most situations, a loan will include equal monthly payments throughout the entire loan term.
For instance, you may pay $1,300 every month on a mortgage until the end of the 30-year term when the house is completely paid off.
But there is a different type of loan available, a “balloon” loan. This loan requires a large one-time payment at the end of the loan term, known as a “balloon payment.”
But what is a balloon payment, exactly? And how should you prepare if you take out one of these loans?
What is a balloon payment?
The balloon payment definition is simply a large one-time payment that comes at the end of a loan. It’s used to pay off the remaining principal of the loan amount.
For instance, a balloon mortgage may require low monthly payments, followed by a $200,000 balloon payment at the end of the loan term.
Balloon payments only apply to balloon loans — a specific type of financial product that is sometimes used for mortgages, business loans and other select loan types.
Most loans don’t have balloon payments, because most aren’t structured this way. The majority of loans will have equal monthly payments.
How do balloon payments work?
Asking “what is a balloon payment?” is really asking what is a balloon loan, as this is the only type of loan that typically requires a large balloon payment.
Balloon loans work like this:
You take out a loan for a specific amount — $300,000 for a mortgage, for instance
You make low monthly payments for the agreed-upon loan length. The term can vary, but 5 to 7 years is typical for balloon mortgages
At the end of the loan term, you must make a large balloon payment that pays off the remaining principal of the loan
In this example, with a 4% interest rate and a 7-year term, your monthly payments would be around $1,432.25 per month, and your balloon payment would be $259,610.29 at the end of the 7-year loan.
In many cases, borrowers will refinance to pay the balloon payment. For instance, they may then take out a 15-year standard mortgage for that $259,610.29 amount, allowing them to make the balloon payment and continue with reasonable monthly payments.
Other borrowers will sell the underlying asset to pay off the balloon loan. For instance, they may live in the house for 7 years and then sell it (for a profit, hopefully) before paying off the balloon payment.
Some balloon loans include interest-only payments, meaning that you just make small monthly payments to cover the interest, and then owe the entire principal balance when the loan term ends.
Other balloon loans have higher monthly payments that cover interest while also reducing your principal balance.
Be sure to read the fine print of any balloon loan agreement to fully understand what you are agreeing to.
Balloon loans vs. traditional loans
Most standard loans are amortized. This means that the total cost of the loan — both principal and interest — is divided into equal monthly payments for the life of the loan.
For example, if you take out a 5-year $10,000 car loan with a 4% interest rate, you’ll pay $184 per month for the next 5 years. The monthly payment will remain the same throughout the loan term.
A balloon loan is different. The monthly payments are much lower, but then a large balloon payment is due at the end of the loan.
Consider the example of taking out a 5-year $10,000 balloon loan with a 4% interest rate. This loan may require a monthly payment of just $47.74 per month for 4 years and 11 months. But the final monthly payment would be a whopping $9,092.61.
You can use a balloon loan calculator to figure out how much you might need to pay as your final balloon payment.
When does a balloon loan make sense?
Traditional loans make more financial sense for most borrowers, as they provide a predictable monthly payment spread out over a long period.
With that said, there are some situations in which balloon loans may be optimal:
When you need lower monthly payments
Balloon loans typically have lower monthly payments than standard loans — but remember that you need a plan for how to pay that balloon payment before the due date arrives.
When you are planning to sell the asset
If you plan to sell the underlying asset, balloon loans may make sense. For instance, if you plan to live in a home for 5 to 7 years and then sell it, you could use the proceeds of the sale to pay off the balloon payment.
When you need time to get your finances in order
If your credit is less than ideal or you expect your income to increase in the future, balloon loans can buy you some time. Then you can refinance into a standard loan once the balloon payment comes due.
With all this in mind, there are substantial risks to taking out a balloon loan. If you’re not able to pay off the balloon payment or you can’t qualify for another loan to refinance, you’ll be forced to default on the loan. This can cause the bank to foreclose on the asset and will damage your credit score.
When are balloon payments allowed?
Balloon payments are only allowed for certain types of loans. They are most commonly used with business loans, short-term mortgages and other specialty financial products.
In general, balloon loans are uncommon. While balloon mortgages are available, the traditional 30-year mortgage is much more popular.
Additionally, balloon loans are subject to financial rules to avoid predatory lending. For instance, according to the Consumer Financial Protection Bureau (CFPB), balloon mortgages are typically not allowed for qualified mortgages.
If you want to learn more about loans, mortgages and credit beyond the question of “what is a balloon payment?” check out some of these useful topics:
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