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What Is a Balloon Payment? How Does It Work?

What Is a Balloon Payment? How Does It Work?
Sheryl Nance-Nash

Sheryl Nance-Nash

Updated November 30, 2021
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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
A balloon payment is a payoff option on a loan that allows you to make a lump sum payment at the end of the loan’s term that is much larger than the preceding payments. This can in turn lower your earlier payments.Balloon payment can be used for everything from mortgage loans to auto loans, though most commonly they’re used for business loans. But why would you opt for this option, and how does a balloon loan work exactly? We cover what you need to know, including the pros and cons of balloon payments.

What Is a Balloon Payment?

There’s a good reason a balloon payment is named as such — it indeed balloons. With a balloon payment, you pay a lump sum at the end of the loan’s term that is typically at least twice as much as the payments you made before it. While installment loans with a balloon option have a series of fixed payments to pay down the balance, balloon payments allow borrowers to reduce the amount of those fixed payments in exchange for making a larger payment at the end. It can sound like a good idea at the outset, but when the end comes and all that money is due, it can be a shock even though you knew it was coming. For that reason, balloon loans are likely most accessible for borrowers who have excellent credit and hefty incomes.

How Does a Balloon Payment Work? 

Balloon loans are typically more short-term loans than traditional installment loans. The large payment can be due after a few months or years.While you enjoy the benefit of reduced initial payments, balloon loans are precarious because of the large payment at the end — particularly if it’s due years later and your situation has changed. Because of their setup, balloon loans tend to be riskier than traditional installment loans. Indeed, there are states that have banned consumer balloon payment mortgages and placed restrictions on balloon auto loans.

How Are Balloon Payments Used in Mortgage Loans?

A balloon mortgage allows you to get a lower monthly payment than you would with a traditional mortgage. For example, an interest-only mortgage loan is a type of balloon loan that allows you to defer paying down principal for 5 to 10 years and instead make only interest payments.Balloon mortgages usually are reserved for the high net worth crowd who can stomach a big hit when the balloon payment comes due. In some cases, borrowers may not even make the balloon payment because they refinance into a different mortgage or sell the house before it comes due.Additionally, balloon payments can be packaged into two-step mortgages. With these, you pay a set interest rate for a certain number of years. Then, the loan resets and the balloon payment rolls into a new or continuing amortized mortgage at the prevailing market rates at the end of that term. The reset process is not automatic with all two-step mortgages though, and if the payment doesn’t reset, the balloon payment will be due.  

How Are Balloon Payments Used in Auto Loans?

While not every car financier will offer a balloon loan, you can find these auto loans. You may not need to meet the stringent requirements that those who want a balloon mortgage may face, but that ultimately may not be a good thing. While you will get lower payments, the truth is that balloon payments aren’t necessarily more affordable — they might just seem that way because of how the cost is divvied up.Understand that you’re banking on the assumption you’ll be making more in the future than you are today, so you will be able to manage the balloon payment when it comes due. That could be the case, but you could also be wrong. It’s a safer bet to take a loan that you can afford today, because who knows what tomorrow might bring.

How Are Balloon Payments Used in Business Loans? 

A balloon loan can be an attractive alternative to a business with short-term financial needs or that needs a loan for commercial real estate purchases, for example. You get the money you need while you wait for that big payday from a customer. In a way, the balloon loan can act as gap financing. A company may want to move into a new office before they’ve sold their current one, for instance, so a deferred payment schedule suits them more than other business loan terms may.Despite the potential benefits, balloon loans are as risky for businesses as they are for regular folks. If your business’s revenue isn’t flush, it’s a bit of a gamble to take on the liability that demands a large lump sum payment. Like with other types of business loans, refinancing may be an option, but there’s no guarantee that a lender will give you a new loan, especially if your business ends up running into any financial challenges. Your situation could worsen if you hit the speed bump that a balloon payment can be.If you’re a business owner, remember you do have further options that you can explore like online business loans.

Advantages and Disadvantages of Balloon Payments

Balloon loans can be a very useful tool for an investor looking to reduce near-term costs to free up capital for other uses, as well as for businesses that need financing right now but can be certain they can comfortably make the balloon payment down the road.It can also be a quicker ticket to home ownership, as the less expensive monthly payment can make it more affordable for your current situation. Paying less each month for a mortgage could also give you more wiggle room to save for retirement or other goals.

Disadvantages of Balloon Payments

Perhaps the biggest disadvantage of a balloon loan may be that the costs of a balloon loan can be higher, particularly if the loan is interest-only.They are also riskier than traditional loans because whether the borrower is a business or an individual, there’s no guarantee that your future income will grow to accommodate the large final payment. Additionally, you can’t be sure that the safety net of a refinance will bail you out of having to make the balloon payment. If you’re a business owner just starting out, for instance, no collateral loans could be a less risky option.A balloon payment also can be problematic in a falling housing market. Owners might not be able to sell their homes for as much as they anticipated before the payment comes due.

Balloon Payment vs Adjustable-Rate Mortgage (ARM)

You’re likely considering a balloon loan because you want the luxury of lower payments, but you might be able to do that with an adjustable-rate mortgage (ARM) as well. It’s worth checking out before you pursue a balloon loan.Typically, ARMs have 30 year-terms, but for a time at the beginning of the loan — typically five, seven or 10 years — your interest rate is lower than what you would get with a comparable fixed-rate mortgage.If you haven’t sold your home by the end of that period, you can refinance into a fixed-rate mortgage or let your ARM adjust based on current market interest rates. You can take comfort in knowing there are caps on how much the interest rate can increase. Once your loan readjusts, it is re-amortized over the remainder of the term. You can expect ARMs to adjust once or twice per year until the loan is paid off. In a rising interest rate environment, this can mean an increase in your monthly payment.An ARM adjusts automatically, unlike some balloon loans. You don’t have to apply for a new loan or refinance like you would with a balloon payment.

The Takeaway

A balloon loan can be a viable tool for meeting your financing needs. However, there are benefits and disadvantages to them to consider to determine if they’d be appropriate for your situation. Because they can be complex, consider consulting with a financial professional for assistance.Whether you’re an individual or a business owner, choosing the right financing is critical. Take advantage of online resources to help you find the right financial solution for your needs, such as comparison shopping for small business loans through Lantern.
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About the Author

Sheryl Nance-Nash

Sheryl Nance-Nash

Sheryl Nance-Nash is a freelance writer specializing in personal finance, business, and travel. Her work has appeared in Money Magazine, Newsday, The New York Times, Business Insider, BBC.com, AARP the Magazine, ABCNews.com, Forbes.com, among others.
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