A balloon payment is a large, lump sum payment that is a higher dollar amount than the regular monthly payment. It is made either at specific intervals, or, more commonly, at the end of a long-term balloon loan. Balloon payments are most commonly found in mortgages, but may be attached to auto and personal loans as well.
In exchange for this large payment, the person taking out the loan reaps of a number of benefits. Usually, the initial amount of cash which must be put down is less than it would be under a standard loan agreement. More importantly, however, this type of loan often has a lower, fixed interest rate throughout the life of the loan and smaller monthly payments. Often short-term, a balloon loan may be beneficial for some borrowers.
When it Makes Sense
Balloon loans are ideal for people with good investment sense, and the ability to wisely manage and ration their spending. By freeing up capital that was dedicated to paying down higher interest rates and making larger payments, balloon loans give a savvy investor the opportunity to use that capital to save money. These loans make a lot of sense for individuals expecting a financial windfall at some point in the future, perhaps due to a large tax refund, an inheritance, or an expected dividend. Whatever the source, if current cash-flow is not indicative of future capital holdings, a balloon payment may be an intelligent choice.
Making the Payment
Most lenders will want some sort of assurance that the final capital for the balloon payment will appear, although some lenders are more free with the granting of balloon loans. It is imperative, if a large sum of money is not expected to appear, that the borrower pay careful attention to setting aside a minimum amount each month to guarantee he or she will have the money when the balloon payment comes due. For this reason, investing saved capital in high-risk markets is not recommended to those on a balloon payment schedule. Rather, it is suggested to place the extra money in safe growth arenas. Given the long-term nature of most loans balloon payments are scheduled on, this is rarely a problem.
Many lenders will allow the borrower to convert his initial balloon loan into a more traditional loan structure on or near the date the balloon payment becomes due; this may help prevent some home owners from losing their homes. The borrower should make sure this is an option before taking out the loan, and he should also be certain he is willing to risk refinancing at a much higher interest rate when the time comes. In most cases, the outstanding mortgage balance on a balloon loan can usually be refinanced if the borrower has maintained good credit and meets all of the lender's mortgage loan requirements.
Balloon loans and the associated balloon payments can be very attractive due to their extremely low interest rates, but they are often viewed as being too risky for most first-time borrowers. If a borrower is not absolutely certain he can handle the dangers of an impending balloon payment, he may want to look into another option, such as an adjustable-rate mortgage (ARM). ARMs carry similarly low interest rates, with the danger being that they are not fixed and may fluctuate to be higher than current market interest rates. Many borrowers have been hurt when the interest rates on their ARMs jump abruptly, so extensive research should be performed when considering any loan.