Balloon Loans Explained
Have you ever come upon a balloon loan but didn’t know what that it was? For starters, balloon loans are not a standard type of loans, but they can be instrumental in certain situations. A balloon loan has a fixed interest rate and a fixed monthly payment for a certain period of time, usually 5-7 years. When that period ends, the remaining loan balance is due in one lump sum, known as the balloon payment.
This type of loan can look attractive because they usually have lower interest rates. It can also be easier to qualify for since the monthly payments are lower. Nonetheless, it has a considerable downside since you could end up owing a lot more money if you don’t have the money to pay off the loan on the due date.
Make sure you fully understand how it works and whether you will be able to afford the payments, before taking it out.
What Exactly Are Balloon Loans?
A balloon loan typically has a relatively short repayment term that is followed by a much larger final payment.
Here is a quick overview of how the balloon loan works.
The borrower agrees to make regular, monthly payments on the loan for a certain period. When the initial period ends, the borrower then has to pay off the remaining balance of the loan at once.
Because of this structure, balloon loans can be very attractive to borrowers due to lower interest rates and monthly payments than any other types of loans offer. However, it’s vital to be aware of the risks that are involved with this type of financing.
If you’re unable to pay off the balloon payment when the due date comes, you may have to sell the asset that was purchased with the loan. On top of that, if interest rates have risen since you took out the loan, you may find yourself owing more money than the original loan you took out.
How Do Balloon Loans Work?
A balloon loan is a type commonly used for a short-term borrowing need, such as financing the purchase of equipment or real estate. The borrower makes regular payments for a certain time, after which the remaining balance is due in total. In most cases, the borrower will not have enough assets to pay off the entire balance at once, so the loan is typically secured by collateral.
Pros and Cons of Balloon Loans
When it comes to taking out any type of loan, there are always a few pros and cons to them. We will discuss the pros and cons of balloon loans that you should be aware of before deciding to proceed.
Here’s a good thing balloon loans can give you a lower interest rate than other types. This is because you are only paying interest on the amount of money you borrowed, not the total value of the asset.
Another advantage that this type of loan brings is that you can usually get a longer loan term. This means that your monthly payments will be lower, giving you financial relief for some time.
With that said, there are some bad sides too. The biggest one is that you could owe a lot more money at the end of the loan term if the asset doesn’t rise in value.
Plus, if you are unable to make your balloon payment and you used your home as collateral, you could lose it to foreclosure. That’s why it’s imperative to make sure you can afford the payments before taking out a balloon loan.
Pros
A balloon loan can be a great option if you want to finance a large purchase or need a loan with a shorter term. Besides, the interest rate is lower than with other loan types.
In addition, this loan type can provide flexibility in your repayment schedule. If you are expecting a large sum of money in the future, you can make a lump-sum payment to reduce the rest of the balance on your loan.
Lastly, balloon loans can be an excellent way to build equity in your home. You will build equity quickly if you make payments regularly and keep your loan balance low. This way, you can put down a payment for a future home purchase or provide security in the event that you need to sell your home.
Cons
There are several things to consider when taking out a balloon loan, including the following.
With this type of loan, you could end up owing more money than the value of your property. If your property value decreases or you encounter financial difficulties, you may find yourself unable to sell or refinance your property to repay the loan.
The monthly payments might be higher than they would be with a traditional loan because you are paying off the loan over a shorter period of time.
Lenders typically require good credit and a steady income in order to be eligible for this type of financing. If you have a bad credit score, you may not qualify for this type of loan.
Who Typically Uses Balloon Loans?
Balloon loans are most popular among homebuyers who are looking to keep their monthly mortgage payments low. They are also popular among investors who are flipping properties and need to keep their cash flow high.
Before deciding on taking out this loan, read all about the bad sides.
How Do Balloon Loans Differ from Amortization Loans?
Here are several ways how to distinguish balloon loans from amortization loans. First, if you are taking out a balloon loan, you typically have a shorter repayment term. The best example of it is that a balloon loan may have a repayment term of 5 years, while an amortization loan may have a repayment term of 30 years.
Also, a balloon loan will usually require a smaller monthly payment. That’s because the balloon loan’s principal balance is not paid down over the life of the loan, it’s due at the end of the loan’s term.
Because of the aforementioned structure, borrowers usually must refinance the loan or sell the property in order to repay the debt if they don’t manage to pay it out in time. That is not the case with an amortization loan, where you pay off the total over the life of the loan.
Bottom Line
If you are looking to buy a property, you may come across a balloon loan and wondering if you should take one. Here we discussed the pros and cons of taking the loan and all the terms you have to fulfill. A balloon loan is perfect if you are looking to buy and flip the property quickly and you want to keep your cash flow high. However, if you are not confident that you can pay out the entirety of the loan in the end, you might want to reconsider taking it. Of course, all loans have their good and bad sides, so it’s always good to research more about a particular subject.
To summarize, a balloon loan can bring you some benefits, but at the end of the day, if your financial situation isn’t the best, this is not the loan for you. You will need a large amount of money to close the loan once the final payment is due. Be ready for it, and don’t take out this loan before thinking well.
