When choosing a loan for a large purchase, borrowers often have numerous options from which to select. Balloon payments are one such option in which the balance is due in a large lump sum at the end of the loan term. In some cases, this loan structure forces buyers into selling or refinancing their property, which likely equates to more money spent on interest rates and loan origination fees. Advantages, however, are also available with balloon payments, including lower monthly installments, little to no money down and more relaxed qualification parameters. Balloon loans may also provide borrowers with more disposable income that can be invested for wealth building purposes.
Balloon loans are often short-term advances that may range from one to 25 years in duration. In many instances, however, the balance becomes due after a short period, such as three to five years. The balance is paid in a balloon payment, which is one large, lump sum that finalizes the loan.
Balloon payments may be attached to mortgages on real estate as well as automobile and personal loans. For example, a buyer may obtain a five-year balloon mortgage to purchase a new home. Throughout the loan term, he or she likely makes equal monthly payments secured under a fixed interest rate. At the end of the five years, the balloon loan payment is due in full. The buyer must therefore make that payment, refinance the loan or sell the home.
Unlike more traditional advances, the balloon loan does not pay itself off at the end of the finance term. Although periodic payments are made toward the loan, most of that money is applied to interest. In this manner, balloon payments are not effective for building equity into a home.
Borrowers must also plan effectively for the end of a balloon loan term. The principle of this may sound easy, especially when applied to an auto or personal loan. For example, at the end of a three-year loan term, the borrower theoretically pays the expected balloon payment and is released from that debt. In reality, however, the borrower must often save capital to ensure that payment is covered. This may prove difficult even when the balloon payment is not due for several years.
Refinancing is not always an option when balloon payments cannot be made, particularly with automobile loans. In those instances where the borrower can refinance, it is likely his or her interest rate will increase from that of the balloon loan. This may cause the payments to rise as well. With such a scenario, the borrower has paid interest on two separate loans that is likely much higher than the original principal cost of the vehicle.
Benefits may also be gleaned from the loan terms afforded by balloon payments. These arrangements, for example, often provide borrowers with lower monthly installments than conventional loan programs. As balloon installments often go toward interest only, the principal is not a considerable factor. Some balloon loans are even structured so the interest due on the loan is covered by the monthly installment. The balloon payment then covers the principal, and buyers know in advance the exact amount needed to pay the loan in full.
Although conventional financing often requires the borrower to put money down, balloon payments usually forego this obligation. In this manner, balloon loan payments may have less stringent qualification parameters. The down payment may therefore be applied to the lump sum due at the end of the term. Another option is to invest that money into a short-term wealth program so it increases in size before the balloon payment is due.
Home buyers may also use balloon payments when they intend to sell the home before the loan is due. In a seller’s market, this may prove beneficial for increasing wealth. The lower monthly payments may also provide borrowers with more disposable income that can be invested for wealth management. This may be especially attractive during times of economic hardship.