Balloon Payments: Definition and Benefits
A balloon payment is a lump sum payment that is attached to a loan. The payment, which has a higher value than your regular repayment charges, can be applied at regular intervals or, as is more usual, at the end of a loan period.
Typically, any loan agreement you have that comes with a balloon payment is known as a 'balloon loan' and runs over a longer term (although this isn't always the case, just think, 'big loan - big final payment').
If you want to see an example of a balloon payment then look no further than the mortgage marketplace (in fact, you may unknowingly have one of these financial arrangements in place but simply didn't know the official phrase). But it's not just mortgages that are liable for balloon payments - automobile sellers and personal loan lenders regularly attach one-off, lump sum payments to any offer they put in front of you. It is for that reason that we include options for balloon payments in our loan calculator and car loan payoff calculator.
How do balloon payments work?
Now you know what balloon payments and loans are, let's take a look at exactly how they work.
Typically, the type of loans that have a final, or regular, balloon payments are used to offset the low amount of money that you would put into a loan agreement.
Take a mortgage as a prime example: many lenders are nervous about handing out cash to borrowers who are short on equity. In most cases, the more money you have to put down as equity the lower the interest rates on your repayments. But some of us don't have hundreds of thousands of dollars to hand, so we opt for balloon loans.
By placing a large, fixed sum final payment on your mortgage, the lender can help to cut the interest rate and your monthly repayments. Not only does this help ensure you won't run short of money due to the eye-watering high monthly repayments, but it means you're unlikely to be the subject of foreclosure (which means the lender will lose money when your former home is auctioned off for a fraction of its original value).
Is a balloon payment right for you?
This is very subjective - i.e. it all depends on what you need to borrow and how much you can repay. Also, to get the most out of this type of loan, you need to be pretty savvy. You know that, at some point in the future, you're going to be liable for a large, one-off hit. If you're the kind of person who's comfortable with saving all their spare money in readiness to pay off the balloon payment when it's due then this is probably the best option for you.
Likewise, if you're a serious investor who understands how to use capital to earn even more money before having to pay off their debts, then balloon loans may be just the ticket. Finally, if you're in a position where you know you're going to benefit from an inheritance or major pay out at a fixed point in the future, you can use balloon loans to cut back on your monthly outgoings.
How do you make a balloon payment?
After the fact that you need to sign the loan agreement, this is the easiest part of the process. When you reach the date specified in the agreement you simply hand over the cash sum stipulated in your agreement and the job is done.
But did you really think it would that simple? Did you think that your happy-go-lucky bank manager was going to hand you a mortgage on a silver platter in return for some vague promise that you'd pay him at some point, "scout's honor"?
No, in the vast majority, if not all, cases, your lender will insist on proof that you can pay off any future balloon payment. Lenders tend to encourage borrowers to invest their spare money in safe growth funds that will, over the course of a set period of years, pay out a final, fixed sum (something like a TFSA - Tax Free Savings Account). What they don't like is their customers dabbling in investing in high risk markets and shares.
Can you convert a balloon loan?
Most lenders will let you convert your original balloon loan into a traditional loan. Typically, this is done near, or on, the date that your balloon repayment is due. This process has found increasing popularity amongst homeowners who, for one reason or another, have failed to save enough money to meet the final payment demand.
As long as your credit is good, your lender shouldn't have a problem refinancing your debt.