What is a Balloon Payment?
When you think about a balloon, you probably think about a festive decoration used to mark some sort of celebration. However, what does a balloon mean in terms of getting a loan? More specifically, what is a balloon payment? Let's start at the beginning. If you get a loan and the payments are not evenly spread over the life of the loan, you will be left with a balance due at the date of maturity.
The final payment is called a balloon payment due to its large size. Since most people do not have the money to cover the balloon payment at the final maturity date, the date on which the loan must be paid in full, individuals often refinance the payment. However, refinancing always carries a certain amount of risk, because you might not be able to refinance the loan at the time of the balloon payment.
If you are not able to refinance and have insufficient liquid funds, the lender may not get their payment on time. In terms of a mortgage, you can usually reset, or extend the life of your loan, if you have not been late on your payments, lost a large portion of your household income, or entered foreclosure.
Two-step Mortgage Balloon Payment
Although balloon payments can occur with any type of amortized loan, a loan that has payments spread over multiple periods, you will often find an oversized payment due at the end of a mortgage. Balloon payments can occur within both a fixed-rate or adjustable-rate mortgage. As stated above, since most people cannot afford a balloon payment at the end of their loan, they can take advantage of a "two-step" mortgage plan.
In a "two-step" mortgage, the balloon payment is rolled into a new or continuing amortized mortgage at the current market rates. Most borrowers plan in advance to either refinance their mortgage close to the date when the balloon payment is due, or sell their home before the maturity date of their loan. However, if the housing market is a bit shaky and prices are falling, you might not be able to sell your home for the price you anticipated, because the positive equity in your home also decreases.
Since a balloon payment is typically more than two times the loan's average monthly payment, often totaling tens of thousands of dollars, you must be prepared to fork over a substantial amount of money at one time. A balloon payment loan often has the advantage of having lower monthly payments before the balloon payment is due, but you should only consider this type of loan if you are able to pay a large amount of money at the date of maturity. You should not assume that you will be able to sell your home or refinance your loan before you have to make a balloon payment, because no one has a crystal ball to predict the financial landscape in the future. If you don't have enough money in your savings account and alternative options are not feasible when it's time to make your balloon payment, consider another type of loan in order to avoid a large amount of frustration.
Example of a Balloon Payment
Finally, let's examine a real-world example in order to fully understand the ins and outs of a balloon payment. If you buy a home and agree on a balloon mortgage, you will start out making monthly payments that are similar to a standard 30-year fixed mortgage at the same interest rate. However, after a certain period of time, usually five to seven years, you will stop making regular payments and be required to pay off the entire loan balance at once.
To put it simply, a balloon mortgage can be thought of as a short-term loan that is disguised as a long-term loan for the first couple of years. A $200,000 loan may be based on a 30-year payment plan, but the loan balance will be due in five years instead of 30. As is the case with any type of loan, be sure you fully understand how a balloon payment works, as well as if you can afford it, prior to signing on the dotted line.