Compare to Other Loans
Standard loans like 30-year fixed-rate mortgages and 5-year auto loans are fully amortizing loans. With those loans, you pay down the loan balance slowly over the entire term of the loan. With each monthly payment, a portion of the payment covers your interest costs, and the remainder goes toward reducing your loan balance. Your interest costs are at their highest in the early years, and most of the loan balance gets paid off in later years. You might even pay more in interest than you pay towards the principal in some months. On the other hand, with a balloon mortgage, you pay mostly interest for a few years until you make a substantial payment to wipe out the remaining loan balance. There’s no gradual shift toward principal repayment.
When Your Balloon Payment Is Due
If you’re considering a balloon loan, it’s crucial to plan for your inevitable balloon payment. Start that process before you even apply for the loan, and keep in mind that things don’t always work out as expected. You can handle a balloon payment in several different ways. It’s great to plan for the future, but it’s also wise to develop a backup plan in case things don’t work out the way you hope. If you have to sell for less than you owe, your credit may suffer, and you might have to repay a loan on a property you no longer own if it’s a recourse loan.
What Are Balloon Loans Used For?
Balloon loans may be useful in a variety of situations.
Business Financing
Balloon loans can help with purchasing or expanding businesses. Especially for new businesses, cash is in short supply, and the company doesn’t have any credit history (that’s why it’s important to build credit for your business). When buying a business, the seller or lenders might offer a balloon loan with relatively small payments, which allows the new business owner to show that they will make payments as agreed. For example, payments might be calculated as if the loan will be paid off over 10 years (keeping the monthly payment low), but with a balloon payment due after three years. After three years of on-time payments, the buyer should have an easier time getting approval from a bank.
Home Purchase
Balloon loans can also be useful when buying a home. In some cases, a payment is calculated for an amortizing 30-year mortgage, but a balloon payment is due after five or seven years (with only a small portion of the loan balance paid off). In other cases, borrowers pay interest-only until the balloon payment is due. Those approaches make monthly payments affordable, but they’re risky. You’ll owe a lot of money someday, and you’ll lose your home and ruin your credit if you can’t pay off the loan.
Construction and Land Loans
Along similar lines, you might use a balloon loan for temporary financing while building a home. To encourage you to keep progressing on your project, lenders might use loans that feature a balloon payment in two to five years—but the monthly payments are calculated as if you have a 30-year mortgage. That gives you time to buy land, build, and refinance with more traditional permanent financing.
Auto Loans
You can even find auto loans that incorporate balloon payments and help buyers obtain a low monthly payment. But with automobiles, balloon loans are especially risky because cars are depreciating assets—they lose value over time. In five years, you’re left with an auto that’s worth significantly less than you paid for it, and you have to pay off most of what you borrowed. You can try to sell the car, but it’s unlikely that you’ll get enough to cover the loan. As a result, you may have to write a check when you sell, and selling a car that you still owe money on is hard. Alternatively, you could refinance and stretch the loan out for a few more years, leaving you upside-down. You’ll almost certainly owe more than the car is worth if you take that approach.
