How do balloon loans work?

Balloon loans are, basically, any type of loans with a special system of payments, called “balloon”. Mortgages and car loans are the most common loans with a balloon payment and it has several reasons why.

Balloon loans can be a highly beneficial alternative to traditional loans as it has a special structure of payments that allow borrowers save money in the beginning of the loan’s period in order to get their feet back on the ground right after the buying the house (or another valuable property).

In short: the borrower may pay less in the beginning and repay the whole loan at the end of the debt’s lifetime.

Types of balloon loans

The most common type of balloon loans is mortgage loan with a significantly shorter lifetime than usually. Mortgages – long-term home loans where the body of the loan is not fully amortized by the end of the term. Normally, home loans (mortgages) are granted for a period of 20-10 years with payments that are built of the interest rate and a part of debt’s principal balance. Those payments amounts are either equal to each other or decrease each month as the principal balance of the loan becomes smaller.

Balloon mortgages mean the lion part of the loan is paid at the end of the loan’s term, where the “balloon” gains its biggest size. The whole amount of the balloon mortgage is repaid right at the date of the loan’s expiration. The payment is made by one single installment.

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Another version of balloon mortgage is the loans with the gradually growing payments with the last largest payment at the ending date.

Personal loans with balloon type of payments are also quite common as it gives a borrower time to collect the needed amount in order to make the payment at the end of the terms.

Car loans can also be repaid on balloon payment terms. Car balloon loans are especially beneficial for those who are buying a car for business purposes (for example for self-employment taxi-drivers who will use the car as a taxi). In this case, a borrower has an opportunity to earn money by driving his new car and paying the only interest rate for the loan. At the end of the loan’s term, the borrower already has the needed amount to repay the loan so both parties (lender and a borrower) are happy.

The specifics of balloon payments

Let’s say someone has got the long-term balloon loan for buying a property. The borrower either doesn’t have enough money to pay significant monthly sums for a loan or he doesn’t want to withdraw funds from his investment projects to make these monthly payments. By the end of the loan’s term, the investor can release needed amount from his projects to make a balloon payment comfortably without financial damage for his business.

payments

Some lenders allow transforming the balloon loan to a loan with a traditional type of payment installments closer to the end of the loan’s term. This gives much greater freedom to borrowers in terms of budget planning.

Pitfalls of co-signing a balloon loan

It stands to reason that balloon loans are at a higher risk to a lender as the lender must be sure a borrower will have a needed amount at the end of the loan’s term to make a balloon payment. This amount is almost equal to the amount of the borrowed money itself, so the lender imposes much tougher requirements to a borrower’s solvency and credibility. Taking into account that car loans or personal loans that are not backed by collateral could be too risky for a bank, the borrower must have an excellent credit score (above 700) and an extensive successful credit history.

Business Loan

Benefits and risks of a balloon loan

Benefits:

cash loan in hand

Risks:

  • Borrower may not find the whole amount to repay the loan as the balloon payment equals to a whole loan’s amount;
  • If the investor gets a balloon loan in expectations of income in the future (so he is able to repay the loan), there is a risk that in a case of absence of expected income, he will fail to make a balloon payment and the property will be foreclosed.