How Balloon Loans Work
Not as Much Fun as the Name Suggests
A balloon loan is a loan that you pay off with a single, final payment. Instead of a fixed monthly payment that gradually eliminates your debt, you typically make relatively small monthly payments. But those payments are not sufficient to pay off the loan before it comes due. As a result, you need to make a final “balloon” payment to pay off the remaining loan balance, and that payment may be significant.
Compare to Other Loans
Standard loans like 30-year fixed-rate mortgages and 5-year auto loans are fully amortizing loans. With those loans, you pay down the loan balance slowly over the entire term of the loan.
With each monthly payment, a portion of the payment covers your interest costs, and the remainder goes toward reducing your loan balance. Your interest costs are at their highest in the early years, and most of the loan balance gets paid off in later years. You might even pay more in interest than you pay towards the principal in some months.
With a balloon loan, on the other hand, you pay mostly interest for a few years—until you make a substantial payment to wipe out the remaining loan balance. There’s no gradual shift toward principal repayment.
The amount of time before your balloon is due varies, but five to seven years is a typical time frame.
What Happens When the Balloon Payment Is Due?
If you’re considering a balloon loan, it’s crucial to plan for your inevitable balloon payment. Start that process before you even apply for the loan, and keep in mind that things don’t always work out as expected.
You can handle a balloon payment in several different ways.
1. Refinance: When the balloon payment is due, one option is to pay it off by obtaining another loan. In other words, you refinance. That new loan will extend your repayment period, perhaps adding another five to seven years (or you might refinance a home loan into a 15- or 30-year mortgage). To pull this off, you need to be able to qualify for the new loan—so your credit, income, and assets need to be in good shape when your balloon payment is due.
If you refinance with a long-term loan, you may end up paying a significant amount in interest because you’re borrowing for an extended period. Hopefully, interest rates will be the same as they were when you first borrowed (or lower) when you refinance. If not, it might have been better to use a traditional amortizing loan—if that was an option.
2. Sell the asset: Another option for dealing with a balloon payment is to sell whatever you bought with the loan. If you purchased a home or an auto, you can sell it and use the proceeds to pay off the loan in full. But that assumes the asset will be worth enough to cover the loan balance. In the housing and mortgage crisis, some borrowers found that their homes were worth significantly less than they owed.
3. Pay it off: If cash flow is not a problem, you can simply pay off the loan when it comes due. This isn’t always feasible—a lack of funds is why you borrowed in the first place, and balloon payments can be tens of thousands of dollars or more. But there may be situations when you can generate the cash you need before the balloon payment is due.
It’s great to plan for the future, but it’s wise to develop a backup plan in case things don’t work out the way you hope. If you have to sell for less than you owe, your credit may suffer, and you might have to repay a loan on a property you no longer own if it’s a recourse loan.
What Are Balloon Loans Used For?
Balloon loans may be useful in a variety of situations, including:
Business financing: Balloon loans can help with purchasing or expanding businesses. Especially for new businesses, cash is in short supply, and the company does not have any credit history (that’s why it’s important to build credit for your business). When buying a business, the seller or lenders might offer a balloon loan with relatively small payments, which allows the new business owner to show that she will make payments as agreed. For example, payments might be calculated as if the loan will be paid off over ten years (keeping the monthly payment low), but with a balloon payment due after three years.
After three years of on-time payments, the buyer should have an easier time getting approval from a bank.
Home purchase: Balloon loans can also be useful when buying a home. In some cases, a payment is calculated for an amortizing 30-year mortgage, but a balloon payment is due after five or seven years (with only a small portion of the loan balance paid off). In other cases, borrowers pay interest-only until the balloon payment is due. Those approaches make monthly payments affordable, but they’re risky: You’ll owe a lot of money someday, and you’ll lose your home and ruin your credit if you can’t pay off the loan.
Construction and land loans: Along similar lines, you might use a balloon loan for temporary financing while building a home. To encourage you to keep progressing on your project, lenders might use loans that feature a balloon payment in two to five years—but monthly payments are calculated as if you have a 30-year mortgage. That gives you time to buy land, build, and refinance with more traditional permanent financing.
Auto loans: You can even find auto loans that incorporate balloon payments and help buyers obtain a low monthly payment. But with automobiles, balloon loans are especially risky because cars are depreciating assets—they lose value over time (“as soon as you drive off the dealership lot,” as they say). So, in five years you’re left with an auto that’s worth significantly less than you paid for it, and you have to pay off most of what you borrowed.
You can try to sell the car, but it’s unlikely that you’ll get enough to cover the loan. As a result, you may have to write a check when you sell, and selling a car that you still owe money on is hard. Alternatively, you could refinance and stretch the loan out for a few more years, leaving you upside-down. You’ll almost certainly owe more than the car is worth if you take that approach.