A balloon loan can be helpful if you need a large sum of money for a temporary project that will eventually pay off.
But let borrowers be warned: if things don’t play out as you planned, the balloon could (quite literally) burst and leave you in bad shape.
Here’s everything you need to know about balloon loans and how to handle them carefully when using them.
What is a Balloon Loan?
Unlike a regular loan, which requires equal monthly payments covering the total loan amount and interest, a balloon loan requires only small payments (usually just the interest) until the big final payment (balloon) is due at the end.
This strategy comes with risks. For example, during the 2008-2009 financial crisis, the U.S. housing market caused a global recession by bundling risky mortgages to many homeowners who couldn’t pay them back.
Even after a global meltdown, balloon loans are still used today (with tact) for business investments, auto loans, and mortgage payments.
How Balloon Payments Work
Usually, a balloon payment only requires you to pay interest each month rather than paying off any amount of the principal. Unlike a regular loan, the total amount of the loan you borrowed will not decrease over time but remain the same.
Balloon loans are typically fixed-rate loans, meaning the interest rate stays the same throughout the life of the loan since the principal amount does not change.
If you’re starting a new venture and need to keep initial costs low until your income increases, this payment structure might be a good fit for you.
Best Ways to Use Balloon Payments
Business Loans
Balloon loans are more successfully used by business owners with good credit, who can secure enough profits from their business over time to pay off the total loan amount.
Businesses use balloon loans to pay for short-term needs for things like:
New business initiatives: Starting or expanding new projects can keep initial costs low until the business grows and earns enough to manage the large payment.
Equipment rentals: Businesses can use balloon loans to rent expensive equipment to complete projects, managing their cash flow until they generate enough revenue to pay it back.
Cash Flow Management: Businesses might use balloon loans to cover unexpected expenses or preserve assets during slower seasons.
Property Acquisitions: If a business needs to purchase more property or assets to accommodate growth, a balloon loan can help cover initial expenses.
Balloon Mortgages
Balloon mortgages can be a convenient way to keep your property costs low initially, but they can be very risky in the end, so it’s important to have a plan.
Here are the differences between regular mortgages and balloon mortgages:
Loan Terms: Instead of making monthly payments on your home for 15 to 30 years, you’ll make smaller payments over 5 to 10 years until the large sum is due at the end.
Interest Rates: While a regular mortgage has a fixed interest rate, balloon mortgage interest rates may be fixed for a while but increase later based on the market.
Here are the types of balloon mortgages you can get:
Interest and principal payments: Your monthly payments will be as low as if you’re paying off the mortgage over a span of 15 to 30 years. In some cases, the payments may go up based on the market.
Interest-only payments: This is where you’d only pay for the interest of your loan until the end of your payment period when the total amount is due.
No payments: Usually, this term extends for a shorter amount of time, and you won’t make any payments until the final amount is due at the end of the term.
Balloon mortgages are a tempting alternative, but they are usually better for people who are prepared to pay off a large sum later on and are confident they’ll have the funds.
For example, it works well for house flippers because the borrower has time to remodel the house and use the money earned when it’s sold to pay off the balloon amount.
Homeowners who plan to sell their house before the balloon payment deadline can also benefit from a balloon mortgage.
Auto Loans
Maybe you’re desperate for a vehicle, but you can’t afford the high monthly payments. Using a balloon loan can help you secure a vehicle for a few years until your income allows you to afford a vehicle payment.
Borrowers sometimes find it easier to secure balloon loans for automobiles because there are fewer restrictions, and the standard car loan term can be up to 6 years.
Disadvantages of Balloon Payments
Risk of Foreclosure
Homeowners with a balloon mortgage may plan to sell their homes to cover the total cost of the loan. However, in a falling housing market, you may not be able to list your home for as much as you need, and it may be difficult to even sell your home at all.
In this case, you could take out another loan to cover the upcoming balloon mortgage payment or be forced into foreclosure and lose your home.
Difficulty Refinancing
Since balloon loans usually only cover interest until the final payment, even after years of making payments, you’ll have very little equity in the property you’re financing.
This can make it hard to refinance and get a new loan because the value you owe may be close to or higher than the asset’s worth. Unless you can come up with a downpayment, you may be at risk of defaulting on the loan.
Harder to Qualify For
Since the risks are higher and you won’t be paying off the loan’s main balance at first, lenders look for borrowers with a good credit history or a large down payment. The interest rates are often a lot higher for balloon loans as well.
Are Balloon Payments Right for You?
If you’re thinking about borrowing a balloon loan, it may be beneficial to meet with a financial advisor to assess your income and credit history and formulate a plan to pay off the balloon amount when it comes.
If you need help determining if a balloon loan is right for you, AMG Finance is here to help with professional loan advice and various loan products designed to meet your needs.
Contact us today, and we’ll help you get the cash you need to meet your goals.
