What is a Balloon Payment?
Definition: A balloon payment is when the entire loan balance is due and payable. It occurs when a loan is not amortized. The loan itself generally contains an early due date, involving the payoff of an existing loan balance. Interest-only loans, also known as straight notes, generally contain a balloon payment provision, but you can find these provisions in adjustable-rate mortgage loans as well.
Although it is possible for a financing contract to involve a balloon payment for a non-real estate related loan, the most common usage of a balloon payment is related to a home mortgage. How these types of payments occur depends on the type of loan.
When I started selling real estate in the late 1970s, it was common to see balloon payment language as part of the financing. To make a home "pencil" for an investor, meaning to provide cash flow or a breakeven point, it was not unusual to take title subject to the existing loan and give the seller a second mortgage without any payments. This was known as a straight note.
As long as the second mortgage was small, maybe less than 10% of the purchase price, not making any payments on the loan was one way to generate cash flow. An investor could receive a positive cash flow this way because the existing mortgage payment, plus the insurance and taxes, were generally low enough that the investor could see some sort of return from the rental payment after the expenses were paid.
This practice presumed that the property would appreciate over the term of that second mortgage, which was generally three years. The late 1970s were a time of high appreciation rates on top of high interest rates. The reason this worked so well was because 90% of the property value was appreciating, while only 10% of the value was defrayed.
So a $100,000 home, in practice, could be worth $133,100 at 10% appreciation after 3 years, which was more than enough to pay off a $10,000 promissory note at 10% interest, even with compounded interest.
The inherent risk is what happens if there is no appreciation or, worse, the market falls? That's how some homeowners in 2007 got into hot water due to dealing with subprime mortgage lenders. One of the popular financing options then were Option ARM mortgages, which contain interest-only payment options, coupled with a balloon payment.
A homeowner during those years might buy a home with no-money down, take out an 80 / 20 combo loan, and both loans could be due and payable with a balloon payment at the end of 5 or 7 years. In declining markets, it made it impossible to sell a home and pay off the loans without resorting to a short sale. Another option, of course, that many people grabbed was to walk away from the home.
None of those options were things the borrowers thought about when they bought the home. They believed the hype that real estate would always go up, that values would never fall. Then they ended up owing more than the home was worth and could not meet the balloon payment obligation.
As long as borrowers understand the risk and are willing to subsidize a balloon payment out-of-pocket, without pinning hopes on appreciation, a balloon payment loan might be the answer. For example, if you're receiving an inheritance that takes time to work through probate.
Examples: A $100,000 loan may be amortized for 30 years, but due and payable in five years. This means the buyer will make amortized payments, based on a 30-year payment plan, but the loan balance will be due in five years instead of 30, resulting in a balloon payment.
Because the biggest portion of a principal and interest payment in the early years of an amortized loan is interest, a five-year balloon payment will be close to the original unpaid balance. If only interest-only payments are paid, the original unpaid balance will be the balance due at the end of the loan term.
Also Known As: lump sum payment
Common Misspellings: baloon payment, ballon payment
At the time of writing, Elizabeth Weintraub, CalBRE #00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.