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Balloon payment loans are set up over a short-term period, marked by small, consistent payments throughout the duration of the loan. The remaining balance is then due as a much larger final payment when the loan term ends. This large final payment is referred to as a ‘balloon payment.’
What is the meaning of balloon payment?
A balloon payment marks the end of a short-term balloon loan. Typically, balloon payments are at least twice the size of previous payments made throughout the course of the loan. The inflated size of the final payment is what earns it the ‘balloon’ moniker.
Balloon loans cover all types of loans, from mortgages to commercial loans. However, they’re more common in commercial rather than consumer lending. This is because businesses are better able to afford a large balloon payment at the end of the lending period, in comparison to the average homeowner with a 30-year mortgage.
Balloon payment mortgages
Balloon payment mortgages are bundled into two phases. During the initial phase, the borrower makes regular payments over a predetermined period. Interest rates are fixed for this initial phase of the loan.
During the second phase, the loan is reset with a new amortized mortgage at market rates. The balloon payment that would have been due is packaged into this second payment plan. However, it’s important to note that the reset process can be called off with some two-step mortgages. If the borrower’s income has changed significantly or he has been unable to make timely payments, the mortgage may not be reset. In this case, the balloon payment would be due.
Commercial balloon payment loans
As with home buying, balloon loans are used by businesses to purchase commercial real estate. Business owners might use balloon loans to bridge the gap for short-term financing. One example would be moving into a new office while waiting for the current one to be sold. In this case, the funds for the large balloon payment would come from the current office sale, buying the business time before the sale is finalised.
Advantages of balloon payments
The primary benefit of a balloon payment loan is access to immediate capital. This is beneficial for entrepreneurs or start-up businesses that have long-term financing in place. Fixed repayments are smaller while the business is just starting out and can be repaid with a larger sum in the future once the financing has been finalised.
Balloon loans usually involve shorter terms overall than traditional loans. This makes them beneficial to borrowers who need a short-term infusion of cash and have the means to pay it off within months or a couple of years.
Drawbacks of balloon payments
The main downside to balloon payments is that there is some element of risk, particularly in relation to the housing market. If you take out a balloon payment mortgage, there’s the potential for housing prices to fall. In this case, homeowners may not have the positive home equity they were banking on. This would put them in a difficult position for paying off a hefty balloon payment, even leading them to default on the loan.
There’s a similar risk for balloon payment loans taken out to pay for automobiles or businesses, as well. This type of loan depends on the borrower’s ability to pay a large sum at the conclusion of the lending period. Because a borrower’s financial circumstances can change, extra scrutiny is needed from the lender’s side.
Finally, long-term lending costs are often higher, particularly if you’re taking out an interest-only loan.
Balloon payment finance criteria
Due to the risk involved, there are strict lending criteria for balloon loans. Businesses or consumers can expect to prove they have adequate assets, stable income streams, and excellent credit ratings. When taking out a balloon payment mortgage, a higher deposit is usually also required.
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