The dreaded balloon payment


The Bottom Line A balloon payment is an extra large, one might say inflated, payment used to pay off a loan. A balloon note is another option for your next mortgage or refinance.

Definition

A balloon payment is a loan payment whose purpose is to pay off the loan. Because paying off a loan entails paying the remaining principal balance and interest accrued since the last normal payment, a balloon payment is usually much larger (even staggeringly larger) than a normal monthly payment. Hence the term "balloon."

Two Types of Loans

The most familiar type of loan is the kind that requires equal monthly payments for a given number of years, for example, a 30-year fixed rate mortgage or a 5-year car loan. If you decide to pay off one of these loans early by fully paying the remaining principal and accrued interest, you are in effect making a balloon payment.

Example: A "normal" loan of $100,000 for 30 years at 7% would be paid off with 360 equal monthly payments of $665.30 (American amortization, Canadian is a bit different).

But, more strictly, the term applies to the mandatory final payment of a "balloon note," which is a loan structured to have a certain number of modest identical monthly payments followed by a final balloon payment. The regular monthly payments on a balloon note are chosen to be the same as the monthly payments on a longer term loan, say a 30-year loan. The difference is that the balloon payment is due at the end of 3, 5, 7 or some other number of years, at which point the loan is paid off.

Example: A balloon loan of $100,000 at 7% with a the payment schedule of a 30-year loan and balloon payment due in 5 years would have 59 monthly payments of $665.30, just like the normal loan. But the 60th payment, the balloon payment, would be $94,797.06, the sum of the remaining principal of $94,247.28 and the $549.78 of interest accrued between the 59th and 60th payments.

Why get a Balloon Loan?

The main reason to consider a 3, 5, 7 year or longer balloon loan, particularly for a mortgage, is that the interest rate will usually be lower than that on a normal 15- or 30-year loan, and consequently the payments will be a bit lower than those of a longer-duration loan, that is of course, until the balloon payment hits. This option might be necessary to qualify the person for the amount of the loan they want.

This is advantageous if you know you're going to sell your house before the balloon date, or if you want to pay off the loan on the balloon date and know you'll have the money. If either of these assumptions turns out to be wrong, you'll have to scramble for another source of funds on the balloon date.

Another good reason to consider a balloon loan is if you want to get a good interest rate now but think interest rates may be trending downward before the balloon date, at which time you plan to refinance at a lower rate. An adjustable rate mortgage is another way to take advantage of a downward trend in interest rates.

Majestic Mortgage
California Home Loans & Mortgage