Not as much Fun as the Name Suggests
A balloon loan is a loan that eventually gets paid off with one large payment (as opposed to continuously making the same payment until the balance is paid off). Generally you’ll make relatively small monthly payments, but those payments are not enough to pay off the loan before it comes due. At some point, a final payment is required to get rid of the loan, and that payment (the balloon payment) may be extremely large.
More traditional loans (such as 30-year fixed-rate mortgages and 5-year auto loans) are fully amortizing loans. With those loans, you pay down the loan balance gradually over the entire term of the loan; most of the loan gets paid off in later years, while your interest costs are at their highest in the early years (you might even pay more in interest than you pay towards the balance each month). With a balloon loan, on the other hand, you’ll still pay mostly interest for a few years, and then you’ll fast-forward and make a large payment to wipe out the remaining loan balance.
The amount of time before your balloon is due varies, but 5 to 7 years is a common time frame.
What Happens When the Balloon is Due?
If you’re considering a balloon loan, it’s essential to plan for the day when your balloon payment is due. Do this before you even apply for the loan, and keep in mind that things don’t always work out as planned.
In most cases, borrowers take one of the actions below:
Refinance: when the balloon payment is due, one option is to pay it off by getting another loan. In other words, you refinance. Then you’ll start a brand new loan with a longer repayment period (perhaps another 5 to 7 years, or you might refinance a home loan into a 15 or 30-year mortgage). To pull this off, you’ll need to be able to qualify for the new loan – so your credit, income, and assets need to be in good shape when your balloon payment is due.
If you refinance and stretch out the loan, remember that you’ll end up paying more in interest because you’re borrowing for an extended period of time. Hopefully interest rates will be the same as they were when you first borrowed (or lower) when you refinance; if not, it would have been better to use a traditional amortizing loan.
Sell the asset: another option for dealing with the balloon payment is to sell whatever you bought with the loan. If you bought a home or an auto, you can sell it and use the proceeds to pay off the loan in full. Of course, this assumes that the asset is worth enough to cover the loan balance; in the housing and mortgage crisis, some borrowers found that their homes were worth a lot less than they owed.
Pay it off: if cash flow is not a problem, you can simply pay off the loan when it comes due. This is rarely a viable option – that’s why you borrowed in the first place – and balloon payments can be tens of thousands of dollars (or more). However, there may be a situation in which you’re confident that you’ll have the cash you need.
Again, it’s great to plan for the future, but you should also have a backup plan in case things don’t work out the way you anticipated. Consider what’s at stake if you have to sell for less than you owe: your credit will suffer, and you may have to repay a loan that you’re no longer benefitting from if it’s a recourse loan.
What are Balloon Loans Used For?
You might come across balloon loans in a variety of situations, including:
Business financing: balloon loans are sometimes used for purchasing or financing businesses. Especially for new businesses, cash is in short supply, and the business does not have any credit history (that’s why it’s important to build credit for your business). Sellers or lenders might offer a loan that’s easier to deal with, and which gives the new business owner an opportunity to show that she will make payments as agreed: payments might be calculated as if the loan would be paid off over 10 years (so the monthly payment is relatively small), but a balloon payment is due after 3 years.
After 3 years of timely payments, the buyer should have an easier time getting approval from a bank.
Home purchase: balloon loans can also be used to purchase a home. In some cases, a payment is calculated as if you’ve got an amortizing 30-year mortgage (and part of the loan balance is paid off), but a balloon payment is due after 5 or 7 years. In other cases, borrowers pay interest only until the balloon payment is due. This approach might make monthly payments more affordable, but it’s risky: you’ll owe a lot of money someday, and you’ll lose your home and ruin your credit if you can’t come up with the cash.
Auto loans: you can even find auto loans that incorporate balloon payments, and the idea (like with any other loan) is to find a lower monthly payment for the buyer. With automobiles, balloon loans are especially risky because automobiles are depreciating assets – they lose value over time (“as soon as you drive off the dealership lot” as they say). So, in 5 years you’re left with an auto that’s worth a lot less than you paid for it, and you have to pay off most of what you borrowed. You can try to sell the car, but you might not get enough to cover the loan – so you’ll have to write a check (it’s not always easy to sell a car that you still owe money on).
Another alternative is to refinance and stretch the loan out for a few more years, leaving you upside-down; you’ll almost certainly owe more than the car is worth in that case.