If you have a loan with a balloon payment:
Even though they seem appealing, balloon loans can be risky choices for consumers. If you're thinking about getting a balloon loan, you should assess whether you can afford the balloon payment when it's due and how.
In this article, we dissect balloon loans, looking at how they work, the various types, plus the pros and cons.
We'll also suggest some alternatives to balloon loans so you can make an informed decision on what type suits your financial situation.
A balloon loan payment is a form of loan that has smaller monthly payments initially and a single, larger-than-normal payment at the end of the term. Hence the name balloon, because the last installment to pay off the loan is a huge amount.
Balloon loan payments typically exceed two times the loan's average monthly payment and are frequently in the tens of thousands of dollars range.
Balloon loans are usually short-term loans ranging from five to seven years.
These loans don't fully amortize, so payments don't lower the principal balance on the loan.
During the initial period, you'll generally pay lower interest rates and have fixed monthly payments. In some cases, your monthly payments may be interest-only. At the end of the loan, you pay off a huge amount, which would include the principal and whatever interest is left on the loan.
There are 3 types of loans where you can use balloon payments. Let's have a look at them.
Qualified homebuyers can benefit from balloon mortgages to pay less each month for their mortgage. Maybe you decide to make interest-only payments for the first few months, then sell or refinance your home at the conclusion of the loan term to avoid the huge balloon payment.
A balloon mortgage is not without risk, though. You might not be able to sell your home or refinance before the balloon payment is due if the value of your property drops, you lose your job, or you encounter another financial crisis. You run the danger of facing foreclosure if you are unable to make the payment.
However, if you only want to reside in the house for a short period of time or you want to sell it, a balloon mortgage might be an alluring option to save money.
If you need a car but don't have the money to make the exorbitant monthly payments, balloon auto loans are an alternative.
With a balloon payment, you might save $100 or more a month, depending on how much the vehicle costs. The downside of smaller payments is that when the loan for the car expires, a sizable portion of the initial cost will be repaid.
You could try to sell your car if you don't have the final payment, but you might not get enough money to make the balloon payment. This is especially true if you drive your automobile a lot, because it could depreciate more quickly. In this situation, you'll probably need to refinance or pay the loan off on your own dime.
If you miss your payments, your lender could repossess the vehicle, send you to collections, or both. Either way, this puts your credit score at risk, thereby making it more difficult to get financing in the future.
If you're a business owner just starting out and need an influx of cash to fund startup costs, you may take out a short-term balloon loan with the plan to pay it back quickly when you're up and running and have the cash flow.
If you are a business owner in need of cash to start up your business, a short-term balloon loan can be an alternative to inject cash into your business.
A balloon loan comprises a stream of constant payments followed by a large payment at the end, which is called the balloon payment.
In contrast, a fully amortized loan is composed of equal payments, which are paid throughout the life of the loan.
The balloon payment, which comes at the end of a balloon loan, is made up of a series of regular payments.
A completely amortized loan, on the other hand, consists of equal payments made over the course of the loan's life.
For some buyers, a balloon loan has clear advantages, but it also has disadvantages too. Let's explore the pros and cons of balloon loans.
Very little of the principal is being repaid, which results in far lower monthly payments than a standard amortized loan. This may allow someone to borrow more than they might otherwise.
Because of the reduced payment due to the limited paydown of the debt, one does not feel the full impact of high-interest rates.
The terms are typically five to seven years, after which the borrower has the option to refinance, maybe at a reduced interest rate. This avoids committing to decades of payments at a high-interest rate.
But, having a loan with a giant payment of most or all of the principal also has clear disadvantages.
Defaulting on the loan if the borrower cannot convince their current lender or another entity to finance the balloon payment and cannot raise the funds to pay off the principal balance.
Being unable to sell the property at a high enough price to pay the balloon payment, and then defaulting on the loan.
Refinancing a balloon loan is more expensive than an amortized loan. As a result, you end up paying more in terms of monthly payments, which would reduce your chances of attaining financial independence.
A balloon loan is enticing because of the initial lower payments. This can deceive you into borrowing more than you can actually afford. The real risk comes with having to pay the last installment which is the lump sum.
You may find out that you can't afford to part with such money which may lead to a default. That is also a potential road to financial ruin.
A loan with a balloon payment may seem like the ideal answer if you're buying a property or a car because your monthly payments are modest. These loans can be dangerous because the balloon payment is a great deal higher than your normal monthly payment.
If you have a choice, going for amortized loans is usually better in the long term. Alternatively, cultivating good money management skills and avoiding debt altogether is the best way to go.