Loans

What You have to Know About Balloon Payment Loans

EPF Last Update: May 23, 2020

Some loans come with a balloon payment, loans such as mortgages, and commercial ones.

You must understand the structure of your loan as well as what happens when the payment of a balloon is due so that you can avoid financial surprises while paying it off.

Most people become comfortable with the minimum payments on a balloon loan; afterward, they scramble to do refinancing when the balloon payment is due.

What is a Balloon Payment?

A balloon payment refers to a more massive amount that one makes at the end of the term to pay off a loan.

How Balloon Payments Work?

It’s a payment type that comes at the end of the loan term. It acts as the final piece of payment on the loan. There’s a possibility that a balloon payment can be twice or more your usual monthly loan payment. Factors such as the type of loan and the regular payment affect the lump sum at the end of the loan term. And could be as much as thousands of dollars.

A good number of loans with balloon payments are short-term. Your loan term, for example, may extend for about five to seven years until the larger final payment is due. Your lender should give you an amortization plan that has a breakdown of your fees, with both the principal and monthly interest amount included, together with the final balloon payment.

Types of Loans with Balloon Payments?

Here are some of the loan types that borrowers will likely find attached to the balloon payments.

  • Home with balloon payment loan

Mortgage lenders have the freedom of structuring a home loan so that it has a larger final payment, allowing the buyers to make smaller payments earlier on. Occasionally, the payments are only interests, and this implies that your monthly fee applies to the loan’s interest and not the principal.

A balloon payment mortgage remains one of the best options, more so for a buyer of a home with a lower income when first buying the house. However, the said buyer expects a significant increase in the revenue by the time the loan payments period elapses, and a full payment comes calling. One must not confuse these loans with adjustable-rate mortgages, which let you make payments with a lower interest and adjust that rate later on in the loan term.

Qualified mortgages – which are home loans that ensure you’re likely to repay your borrowed amount – have no room for balloon payments.

  • Car with balloon payment loan

Whether you are financing a used or new car via a dealer, online lender, or bank, you can have an option where you get a loan with a balloon payment type. It uses the same basic concept as in the case for a mortgage: For a specific period, you make the monthly payments at the lenders established amount, after which you will make a more significant payment to finalize on loan.

Your lender and loan terms determine whether your rate of interest is fixed or variable. Also, getting a vehicle through this system of payment depends on the make of the car, model, and year of the manufacturing of the automobile you’re buying; its approximate value and the term of the loan length you require plays a part as well.

  • Business loan with balloon payments

A business loan with a balloon payment allows you a room to make smaller payments for a certain period before you can finalize the other bit at once. If, for instance, you are looking to open a new branch of your bar, you could opt to buy a piece of commercial real estate using a short-term loan with a balloon payment that is due in five years. You get the capital required to start your new place, have some time to get your financial and business cash flow together before you can pay your loan when the time arrives.

Is it a Good Idea to Get a Balloon Loan?

As with any other loans, borrowing loans with this system of payment comes with its pros and cons. Balloon payments pose more risks compared to all different kinds of loans and should, therefore, accorded special considerations.

The major risk that comes with this model of payment is that you won’t or might not have the money to pay back the loan the moment you have to make the final payment. Missing the last payment could lead to the lender repossessing your car. In the case of a business loan, any asset used to secure your loan might go to the lender as a collateral. It’s even devastating to use this model to secure a mortgage because a default in payments could lead to you losing your home.

In all the cases mentioned above, a default on loan might end up damaging your credit scores and subject you to the danger of suing the lenders in an attempt to collect any remaining bit of money you owe.

Don’t get it wrong and focus only on the negatives; a balloon loan is advantageous if you can manage the more significant final payments. The initial smaller amounts make it easier for you to pursue your financial objectives, which may include things like buying a car, starting a business or buying a home, especially when you are not earning a lot of money.
As your income grows over time, you must think about sparing some money that you’ll need for the balloon payment, or you can as well decide to make extra payments against the principal in advance if your lender accepts such a move.

What Happen when a Balloon Payment is Due?

You’ll have to make your balloon payment to meet the terms of the agreement of the loan. If it happens that you have no cash on hand, other alternatives can help you manage a balloon payment without necessarily having to risk default or even end up damaging your credit score. Here’s what you can do to be safe.

  • Refinance the loan

Refinancing means that you are taking a new loan to pay off the old one. So, if, for example, you have a car or mortgage loan with a balloon payment that is due in say the next two months, you could settle on using a traditional loan to refinance your remaining loan balance.

When you are with a loan under the balloon system, you’ll have most of your payments go towards the interest rather than the principal amount. If you choose to do the refinance into a new loan, you might still be paying a balance closer to the amount that you borrowed the first time. It, therefore, means all the already paid interest could go to waste.

  • Sell your asset

Sometimes taking a new loan to manage your balloon payment can only sink you into deeper problems. Instead, you can decide to sell the assets that you have, especially the ones that you used to acquire the loan. In the case of a car loan, it would imply that you use the car you purchased and your home for the case of a mortgage.

The one glaring disadvantage is that you lose the asset. However, if you can sell the asset and remain with some cash after settling, the loan would be great instead of losing entirely to foreclosure or repossession. The key here is to be in a position to sell the asset once it has appreciated. If the value of your home drops, you could end up making a meager profit following the sale, or you might end up owing money.

If you have the intention of selling your asset or looking to do a refinance into a new loan, you must give yourself a lot of before the due time for final loan payment. It would be a poor decision to wait until the last minute to try and sell your home or get a loan approval for a new auto loan as there are possibilities that it could backfire, and you end up missing the deadline of the balloon payment.

Reevaluate Your Finances Before Committing to a Balloon Loan

Your lifestyle and the cash flow plays a significant role in deciding whether a balloon loan fits you. A self-employed has unpredictable monthly income compared to an employed counterpart.

On top of your current income, you need to consider your future projected earning together with all your monthly expenses and the possibility of them changing over time. Having a proper account of these will help you decide whether a balloon loan is a sensible move for you and your course.

Conclusion

A balloon payment of the loan is much like any other loans out there. It has its merits and demerits.

However, if you can accurately draw a plan and manage your finances, you will find this system of payment very beneficial. Please take all the precautionary measures that we’ve highlighted in this article to ensure that you get the best out of the balloon loan payment system.

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