A balloon payment refers to a significant sum of money that is required to be paid at the conclusion of the term for a balloon loan.
What Is Balloon Payment?
Balloon Payment vs Fully Amortized Payment
A balloon payment is associated with a balloon loan where all prior payments are relatively smaller than the final single payment that clears the loan. In a fully amortized loan, at the end of the term, the remaining balance needs to be zero to clear the loan.
Where Is Balloon Payment Used?
A balloon payment is most commonly used for the following types of loans:
Balloon payments are often a part of auto loans. It is suitable for users who want to secure a vehicle but do not have the means.
Start-ups benefit from balloon loans as they have a limited amount while starting the company, but if they have a good financial record and a trustworthy credit history, they can take out a balloon loan. The balloon payment would be easier to make from the profit the company makes during the loan period. But the risk of the business failing or experiencing a loss will remain.
Advantages and Disadvantages
The advantage associated with balloon loans is primarily the initial smaller payments required compared to fully amortized loans. Furthermore, it has a shorter underwriting period resulting in low transaction fees and administrative costs. And lastly, balloon payments give the best loan structure for borrowers looking to re-sell their assets soon. In such cases, the selling price covers this payment.
But in a collapsing economy, prices would drop, and the amount received from re-selling might not be enough to cover the balloon payment. The borrower would have to default on their loan and accumulate debt or risk losing their net worth.