What Is A Balloon Payment?
A balloon payment refers to a stream of regular payment followed by a large payment at the end of a loan term. It is different from an amortized loan, which is paid back in small but equal payments. Balloon payments are often twice the amount of the loan’s previous payments.
A balloon payment works for specific income structures. Before banks and other financial institutions can grant a balloon loan, they require evidence that a borrower can afford the balloon payment when it is due. In real estate, balloon payments are more common in commercial lending than residential lending. That is because an average landowner might find it difficult to afford a large sum of money at the end of the loan.
If a borrower has the assurance that they can afford the balloon payment when it is due, then balloon payment can be a good option. Here are the advantages of a balloon payment:
- No deposit is required.
- It helps your cash flow management.
- You pay a lower money requirement fee.
- You can free up short-term capital and cover finance gaps.
However, as much as the benefits are attractive, a balloon payment has its disadvantages. They include:
- Inability to afford your balloon payment may lead to a cycle of debt because you will need to refinance it.
- The loan provider may disapprove refinancing your balloon payment if you can’t pay it when it’s due.
- In real estate, a landowner may have to sell their property to cover up a balloon payment when it’s due.
Aside from the pros and cons, one other thing to know about a balloon payment is “The Interest Rate.” When the interest on a loan increase, the balloon payment can become very large. That is necessary because when the interest is high, a reduction in balloon payment will increase the regular amount, which may affect a borrower’s cash flow.
Balloon Payment Example
A business owner who wants to set up a business that might not yield enough profit at the beginning can opt-in for a balloon payment. By the time the balloon payment is due, the business owner would have made enough money in the business to pay the loan. For instance, Jimmy takes a $100,000 balloon loan to start a business. The loan term is seven years with a 5% interest rate. Jimmy will pay $550 every month for the next seven years. At the end of the loan term, he will pay the remaining balance.« Back to Glossary Index