Understanding Balloon Payment
A balloon payment refers to a large payment made at the end of the term of a balloon loan to settle the remaining balance.
This final payment is considerably more significant than the previous repayments.
Balloon payments are commonly used in loans where the monthly installments are significantly lower than those of a fully amortized loan.
Balloon Payment and Fully Amortized Payment
A balloon payment is a characteristic of a balloon loan, where the preceding payments are relatively smaller than the final single payment that clears the loan.
On the other hand, in a fully amortized loan, the remaining balance must be zero at the end of the loan term.
Usage of Balloon Payment
Balloon payments are frequently utilized in the following types of loans:
- Mortgage: A balloon mortgage suits borrowers who intend to sell the property before the term ends. Balloon mortgages typically span 4 to 6 years, and after the term, the borrower makes the balloon payment to settle the remaining balance. Sometimes, the monthly payments only cover the interest, resulting in the remaining balance equaling the loan amount.
- Auto Loan: Balloon payments are often incorporated into auto loans. This option is suitable for individuals wishing to acquire a vehicle but lacking the means for regular monthly payments.
- Business Loans: Start-up businesses can benefit from balloon loans as they often have limited initial funds. They can opt for a balloon loan with a solid financial record and a reliable credit history. The profits generated during the loan period can more easily cover the balloon payment. However, there is a risk of the business failing or incurring losses.
Advantages and Disadvantages
One advantage of balloon loans is the lower initial payments than fully amortized loans.
Additionally, they have a shorter underwriting period, resulting in lower transaction fees and administrative costs.
Moreover, balloon payments are suitable for borrowers who plan to sell their assets shortly, as the proceeds from the sale can cover the balloon payment.
However, asset prices may decline in an economic downturn, and the proceeds from selling the asset may not be sufficient to cover the balloon payment.
This can lead to defaulting on the loan, accumulating debt, or even risking the loss of one’s net worth.