Balloon payments are large, lump-sum payments made at the end of a loan's term. To learn more, visit our in-depth blog on "What a balloon payment is?". They are most commonly found in car loans. Unlike a typical car loan, which is spread out over several years and involves monthly payments, balloon loans require one final payment to pay off the loan in full.
It's used to pay off the remaining principal on your loan.
A balloon payment is a large, lump-sum payment that's due at the end of a loan with a term shorter than its amortisation schedule. Balloon payment loans offer loan rates a half point to nearly a full point lower than a 30-year fixed rate mortgage. They also add significant risk; you could lose your house.
You'll likely only find balloon mortgages through smaller, local banks and credit unions. So what's the catch? It's in the name — you make monthly payments for most of the term of the loan and then pay off the remaining principal all at once, taking advantage of lower interest rates while they last.
It works like this: You get five years worth of low interest payments, which helps keep your monthly payments low and affordable during those first five years. Then, when your mortgage comes due at year five, you either have to pay off that entire balance or refinance your home into another loan. If you're lucky enough to see an appreciation in value on property during those first five years of home ownership, refinancing may be easy enough to accomplish by paying off some or all of that balance with the equity built up in your home.
With a car loan, balloon payments are usually optional.
With a car loan, balloon payments are usually optional. A lender may require a balloon payment if you have a lower down payment or longer terms on your loan. For example, if you have $5,000 to put toward the purchase of a new car and decide to put down 20 percent with 48-month financing for the remaining balance, your monthly payment will be about $511 per month. If you choose to make an optional balloon payment at the end of the term, this lowers your monthly payment to about $438 because some of what you owe is deferred until the end of your loan term.
If you have bad credit, however, some lenders will require that you make a balloon payment before approving your auto loan application. Along with having more money upfront for a larger down payment and higher interest rates, these lenders require that you repay part of what's owed in full at the end of your 60-month or 72-month loan term. This helps reduce their risk in lending out larger amounts of money over an extended period of time.
But some lenders will offer this option and may require it for loans with low down payments or longer terms.
But some lenders will offer this option and may require it for loans with low down payments or longer terms. Consider the following hypothetical scenario:
Bob Doe wants to buy a $200,000 home. He has $20,000 in savings available for a down payment, but he doesn't want his mortgage payment to be too high. His lender offers him two loan options: one that requires a minimum 5% down and one that requires 10%. However, if Bob goes with the 5% down loan, he must agree to a balloon payment that will be due at the end of five years.
Balloon payments often make sense for buyers who plan to stay in their homes for a short period of time, have other sources of income and know they'll be able to make the final payment.
In most cases, balloon payments are only practical for buyers who are confident in their ability to make the final payment. In particular, you'll want to consider a balloon payment if:
They can also be a good way to get into an expensive home if you can't afford the down payment otherwise.
A balloon payment may be a way to borrow more money than you would otherwise be able to afford, because conventional loan terms typically include strict limits on how much you can borrow. With a balloon payment, lenders are extending credit based on the assumption that your finances will improve at some point before the final payment comes due.
With this added credit, you may be able to invest in the stock market and earn higher returns than what conventional lenders pay. You can also use it to make a bigger down payment on your home and avoid paying insurance premiums for years to come.
If investing or making larger down payments with this added credit isn't an option for you because of income restrictions or other financial circumstances, then consider trying another method for borrowing before resorting to balloon payments as part of your loan agreement.
If you're buying a home, consider whether you'll want to keep it long enough to recoup the costs of making a balloon payment.
If you're buying a home for the first time and considering a balloon payment, it's also important to ask yourself how long you plan to stay in this home. If you plan to upsize or downsize in less than five years, are there any other circumstances that might make the balloon payment worthwhile? For example: if your job requires frequent relocations, will you be able to sell your home quickly without taking a significant loss? Will your property appreciate dramatically during the interim? You'll also want to consider whether or not there's a chance of refinancing down the road. Refinancing might be an option once your credit score improves or if home values increase significantly.
Be aware that some lenders may be willing to renegotiate terms if you run into financial trouble.
Another important thing to keep in mind is that if you know you're going to need help, talk with your lender as soon as possible. If you've been making payments consistently, and have been a good customer, the lender will be more likely to renegotiate the terms than if this is not your first missed payment.
Of course, it's always best to avoid missing a payment in the first place. Don't take on more debt than you can handle; find an affordable home that suits your needs and financial situation; consider alternatives like fixed rate mortgages; and save up for retirement. With these steps taken care of, you can relax knowing that your balloon payment isn't going to cause problems later on.
A balloon payment may work well if you're only planning to stay in your home or keep your car for a few years or already have access to other sources of income.
In the case of a mortgage, you may have difficulty attaining a long-term fixed-rate loan and want to take advantage of current low interest rates. However, in a few years, you might expect to move or sell your home. In this case, it may make sense to go with a balloon mortgage because it will be easier to refinance your loan when the term is up and the market is favourable or sell your home before you are required to make the large lump sum payment.
If you plan on keeping your car for longer than three years, then it's unlikely that a balloon auto loan will be cheaper than other financing options. However, if you're planning on selling or trading in your car before then (or probably won't need another car at all at that point), then figuring out whether there's room for negotiation can help you decide whether it makes sense for you economically.
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