Balloon Loan

A type of loan that does not have to be completely repaid by the end of its term and instead requires a lump sum payment at the end.

What Is a Balloon Loan?

A balloon loan is a type of loan that does not get fully amortized. The payment made at the end of the loan term is referred to as the balloon payment due to its size. A balloon loan is mostly used for short-term loans ranging from 5-7 years and has a relatively lower interest rate initially. 

How Does Balloon Loan Work?

Balloon loans usually have short terms (mostly ranging from 5-7 years), and a small amount of interest is applied to them. The payment method for balloon loans differs from that of a traditional loan. It is not designed to pay the whole loan amount by the end of the term; instead, only a small amount is to be paid monthly. At the end of the term, the principal balance left is to be paid off by a single payment called the balloon payment.

Balloon loans are primarily used for mortgage or auto loans. In a balloon mortgage, the buyer takes out a loan with a low-interest rate; the payment method used is mostly the same as for a 30-year mortgage. After the end of the term, the balloon payment is to be paid off. The buyer has a few options at this stage: sell the property or apply for a traditional loan with lower interest rates than before. There is a risk that the property might not be worth the amount required or that the interest rates are higher. 

Example of Balloon Loan

A person is looking to buy a house worth $200,000. He takes out a balloon loan with an interest rate of 4.5% per month. The term is decided to be seven years. The person has to make a payment of $1,013 per month for the next seven years. At the end of the term, he paid $85,092, and $175,066 remains. This remaining amount will be called a balloon payment. 

Advantages and Disadvantages

Balloon loans are easier for buyers looking for a shorter loan period.

  • Lower monthly payments than traditional loans.

  • Can re-invest after some time with better interest rates and financial standing.

But with all these advantages, balloon payments are also incredibly tricky to deal with. Some of its disadvantages include:

  • Being unable to pay the balloon payment and facing the risk of defaulting on the loan.

  • Being exposed to malpractice where loan sharks might lure you into taking a larger loan.

  • If the economy collapses, you will not be able to sell the property (house or car) at a price that would cover the balloon payment.