Balloon payments: definition and benefits
Sometimes, it can be difficult to fathom out the world of finance. The industry is so littered with phrases that, if you tried to put serious time and effort into trying to decode the strange language used in the world of finance, your brain would probably melt!
But thatís part of the reason why weíre here: to give it to you in simple terms so that you can get on with the serious business of planning your financial future and not worry about how you go about deciphering the terminology.
What is a balloon payment?
Quite simply, a balloon payment is a lump sum payment that is attached to a loan. The payment, which has a higher value than your regular repayment charges, can be applied at regular intervals or, as is more usual, at the end of a loan period. Typically, any loan agreement you have that comes with a balloon payment is known as a Ďballoon loaní, which runs over longer terms (although this isnít always the case, just think, Ďbig loan - big final paymentí).
If you want to see an example of a balloon payment then look no further than the mortgage marketplace (in fact, you may unknowingly have one of these financial arrangements in place but simply didnít know the official phrase). But itís not just mortgages that are liable for balloon payments - automobile sellers and personal loan lenders regularly attach one-off, lump sum payments to any offer they put in front of you.
Balloon payments: the detail
Now you know what balloon payments and loans are, letís take a look at exactly how they work.
Typically, the type of loans that have a final, or regular, balloon payments are used to offset the low amount of money that you would put into a loan agreement.
Take a mortgage as a prime example: many lenders are nervous about handing out cash to borrowers who are short on equity. In most cases, the more money you have to put down as equity the lower the interest rates on your repayments. But some of us donít have hundreds of thousands of dollars to hand, so we opt for balloon loans.
By placing a large, fixed sum final payment on your mortgage, the lender can help to cut the interest rate and your monthly repayments. Not only does this help ensure you wonít run short of money due to the eye-watering high monthly repayments, but it means youíre unlikely to be the subject of foreclosure (which means the lender will lose money when your former home is auctioned off for a fraction of its original value).
Is a balloon payment right for you?
This is very subjective - i.e. it all depends on what you need to borrow and how much you can repay. Also, to get the most out of this type of loan, you need to be pretty savvy. You know that, at some point in the future, youíre going to be liable for a large, one-off hit. If youíre the kind of person whoís comfortable with saving all their spare money in readiness to pay off the balloon payment when itís due then this is probably the best option for you.
Likewise, if youíre a serious investor who understands how to use capital to earn even more money before having to pay off their debts, then balloon loans may be just the ticket. Finally, if youíre in a position where you know youíre going to benefit from an inheritance or major pay out at a fixed point in the future, you can use balloon loans to cut back on your monthly outgoings.
How do you make a balloon payment?
After the fact that you need to sign the loan agreement, this is the easiest part of the process. When you reach the date specified in the agreement you simply hand over the cash sum stipulated in your agreement and the job is done.
But did you really think it would that simple? Did you think that your happy-go-lucky bank manager was going to hand you a mortgage on a silver platter in return for some vague promise that youíd pay him at some point, ďscoutís honorĒ?
No, in the vast majority, if not all, cases, your lender will insist on proof that you can pay off any future balloon payment. Lenders tend to encourage borrowers to invest their spare money in safe growth funds that will, over the course of a set period of years, pay out a final, fixed sum (something like a TFSA - Tax Free Savings Account). What they donít like is their customers dabbling in investing in high risk markets and shares.
Can you convert a balloon loan?
Yes, you can. Most lenders will let you convert your original balloon loan into a traditional loan. Typically, this is done near, or on, the date that your balloon repayment is due. This process has found increasing popularity amongst homeowners who, for one reason or another, have failed to save enough money to meet the final payment demand.
As long as your credit is good, your lender shouldnít have a problem refinancing your debt.
Calculators for balloon payments
Written by James Redden
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Last update: 21 October 2015
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