People love getting creative with their financing. Before the market crash of 2007-2009, many homeowners owned their homes through a series of Option Adjustable Rate Mortgage (ARM) loans. These loans became the house of cards that fell when the market crashed, sending thousands of homeowners into foreclosure. Balloon payments are not much better.
What is a balloon payment?
Although it sounds like prepayment on a birthday party, a balloon payment is much less fun than that. A balloon payment is a large lump sum due at the end of a short-term loan. That short-term loan is known as a balloon loan.
In a balloon loan (also known as a balloon mortgage), you take out a loan for a business, to buy a home or piece of property or an auto loan. The lender takes that amount and either a) amortizes it over a few years or b) has you pay interest only for several years. At the end of both types of loans, a large payment—the balloon payment—is due for the remaining loan balance. The large payment is usually more than twice the monthly payment and can be thousands of dollars.
Many people choose to get a balloon mortgage because they believe they will have more money in the future. They plan on either having enough cash when the balloon payment is due to pay for it outright or to have good enough credit that they can refinance the balloon payment amount.
Balloon Payments and Two-Step Mortgages
In many cases, lenders structure the balloon payment as a two-step mortgage. In two-step mortgages, the borrower pays mortgage payments with one interest rate for the first loan term, which is usually two to five years.
At the end of that step, the interest rate increases to market rates and the balloon mortgage rolls into an amortization schedule. This second step is not always automatic and depends on the borrower's dependability to pay back the loan in a timely manner.
Balloon Payments and Adjustable-Rate Mortgages
Balloon payments are similar to adjustable-rate mortgages (ARM), and although some people confuse the two, they aren't the same.
ARM mortgages start out at a fixed interest rate for the first five to seven years. At the end of the set time period, the loan automatically resets and a fluctuating rate that continues to change periodically over the life of the loan.
Balloon mortgages don't automatically renew at the end of the fixed rate which makes balloon mortgages more difficult to keep track of.
Balloon Payments as Commercial Loans
Many businesses utilize balloon payments as a loan strategy when they don't have enough capital upfront but anticipate getting a large sum of money quickly. This sort of loan is especially appealing to those new businesses that haven't established their credit yet.
Balloon Payments on an Amortized Schedule
A more appealing way to make a balloon payment is to have the lender structure the loan on an amortized schedule for the first five to seven years until the balance is due.
In a 30-year mortgage, the borrower's bill will consist mainly of interest payments for the first few years. As time wears on, the premium payments will outweigh the interest. That schedule is known as amortization.
In an amortized balloon mortgage, then, the lender sets up the loan so you are paying toward the premium as well as the interest throughout the five to seven years. This will make the monthly payments more affordable, but doing so takes on a big risk. At the end of the term, you are going to owe a rather large sum of money.
If you aren't able to pay when the balloon payment is due, you will either have to refinance (which costs much more in interest than a conventional loan) or default on the loan.
Balloon Payments: Good or Bad?
No loan is inherently bad, but the intention behind it certainly can be.
If you are taking out a balloon loan to be able to afford a great new car or upgrade to a house you don't really need, your best bet is to save the money rather than take out that sort of loan.
If you are certain or nearly certain of your business raising capital before the balloon payment is due, a balloon mortgage can be a great way to fund and fill in the gap in the meantime.
The housing market can also affect the quality of the balloon payment. If, for example, you get a balloon mortgage on your house and you pay mostly interest for the first five years, in which time your home value drops significantly, you may have no choice but to default on the loan.
In short, loans with balloon payments are risky for both the borrower and lender. Most lenders will only loan this type of mortgage to those with strong credit history and a good record of paying on time.
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Are you thinking of using a balloon payment as part of your real estate strategy? Talk to your local real estate professional. They may be able to provide alternatives that will suit you and your pocketbook better. Call us today at 1-833-2-CLEVER or fill out our online form to get started.