How Balloon Loans Work
Not as much Fun as the Name Suggests
A balloon loan is a loan that you must pay off with one final, large payment. Instead of continuously making the same monthly payment until you eliminate the debt, you typically make relatively small monthly payments. But those payments are not sufficient to pay off the loan before it comes due. At some point, a final “balloon” payment is required to get rid of the loan, and that payment may be significant.
Compare and Contrast
Standard loans like 30-year fixed-rate mortgages and 5-year auto loans are fully amortizing loans. With those loans, you pay down the loan balance gradually (along with interest costs) over the entire term of the loan. Your interest costs are at their highest in the early years, and most of the loan balance gets paid off in later years. You might even pay more in interest than you pay towards the principal in some months. With a balloon loan, on the other hand, you pay mostly interest for a few years, until you make a substantial payment to wipe out the remaining loan balance.
The amount of time before your balloon is due varies, but five to seven years is a typical time frame.
What Happens When the Balloon Payment Is Due?
If you’re considering a balloon loan, it’s essential to plan for the day of your balloon payment. Start planning before you even apply for the loan, and keep in mind that things don’t always work out as expected.
In most cases, borrowers handle the balloon payment in one of the following ways.
1. Refinance: When the balloon payment is due, one option is to pay it off by getting another loan. In other words, you refinance. You start a brand new loan with a longer repayment period (perhaps another five to seven 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, you may end up paying more in interest because you’re borrowing for an extended period. 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.
2. Sell the asset: Another option for dealing with the balloon payment is to sell whatever you bought with the loan. If you purchased 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.
3. Pay it off: If cash flow is not a problem, you can simply pay off the loan when it comes due. This isn’t always possible—that’s why you borrowed in the first place—and balloon payments can be tens of thousands of dollars (or more). But there may be a situation in which you’re confident 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 may suffer, and you might 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 balloon loan with relatively small payments, and which gives the new business owner an opportunity to show that she will make payments as agreed. For example, payments might be calculated as if the loan will be paid off over ten years (keeping the monthly payment low), but with a balloon payment due after three years.
After three years of timely payments, the buyer should have an easier time getting approval from a bank.
Home purchase: Balloon loans can also be useful when buying 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 gets paid off), but a balloon payment is due after five or seven years. In other cases, borrowers pay interest only until the balloon payment is due. This approach might make monthly payments 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.
Construction and land loans: Along similar lines, you might use a balloon loan for temporary financing while building a home. To encourage you to keep progressing on your project, lenders might use loans that feature a balloon payment in two to five years—but monthly payments are calculated as if you have a 30-year loan. That gives you time to buy land, build, and refinance with more permanent financing.
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 cars are depreciating assets—they lose value over time (“as soon as you drive off the dealership lot,” as they say). So, in five years you’re left with an auto that’s worth significantly 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 might have to write a check when you sell. It can be hard to sell a car that you still owe money on. Alternatively, you could 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.