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A balloon payment is a lump sum that's due when certain types of loans reach their maturity date. These loans generally come with lower monthly payments for the majority of the loan's term, followed by one sizable "balloon" payment at the end of the loan term. Balloon loans are considered riskier than some other types of loans because the final lump-sum payment can often be double that of the loan's fixed monthly payments, sometimes totaling tens of thousands of dollars.
How Do Balloon Payments Work?
Balloon payments are usually required with short-term loans (often three to seven years) that do not fully amortize, so repayments won't lower the principal balance on the loan over time. A balloon payment is required at the end of the term to pay the loan balance in full.
During the initial period, you'll generally pay lower interest rates and have fixed monthly payments. In some cases, your monthly payments may be interest-only. Balloon loans might be a mortgage, auto loan or another type of amortized loan and are considered best for borrowers with a good steady income and excellent credit.
Balloon Mortgages
Balloon mortgages allow qualified homebuyers to enjoy lower monthly mortgage payments. Maybe you choose to make interest-only payments during the initial period, and, at the end of the loan term, sell or refinance your mortgage to avoid the hefty balloon payment.
But a balloon mortgage doesn't come without risk. If the value of your property declines, you lose your job or face another financial hardship, you may not be able to sell or refinance before the balloon payment comes due. If you can't make the payment, you risk losing your home to foreclosure.
However, if you plan only to live in the home for a few years or you'd like to flip the property, a balloon mortgage may be an attractive way to save money before you sell.
Balloon Auto Loans
Balloon auto loans are an option if you need a vehicle and don't have the income to make the high monthly payments. Depending on the vehicle's price, you could save $100 or more every month with a balloon payment. However, the tradeoff to lower payments is that a big chunk of the vehicle's original cost is due when the car loan matures.
If you lack the final payment, you could try to sell your car but you may not get enough to cover the balloon payment. This is especially true if you drive your car a lot, causing the potential for faster depreciation. In this case, you'll likely have to refinance or pay off the loan out of pocket.
Skip your balloon payments and your lender could repossess your vehicle, send you to collections or both. Either way, you risk damaging your credit, making it difficult to get financing in the future.
Short-Term Balloon Loans
If you're a business owner just starting out and need an influx of cash to fund startup costs, you may take out a short-term balloon loan with the plan to pay it back quickly when you're up and running and have the cash flow.
Pros and Cons of Balloon Payments
In many instances, balloon payments can be beneficial.
Pros
- You can borrow larger amounts. Because you're making smaller or interest-only payments, you may be able to borrow a larger amount than with a traditional amortized loan.
- Make lower initial payments. During the fixed period, your monthly payments are usually smaller than many other loans, which is helpful if you have limited income.
- They have shorter terms. Balloon payments are potentially favorable short-term borrowing options for someone expecting a lump payment before the end of the loan term, such as a seasonal worker.
Cons
Balloon payments also have several disadvantages to keep in mind.
- You're building little equity. With a balloon mortgage, you generally pay little or nothing towards the principal. For that reason, you also build little to no home equity. This can make it more challenging to refinance or put a sizable down payment on another property when it's time to sell.
- Shelling out a high final payment. It's risky to take on a mortgage or other loan with a large payment due at the end. If you can't come up with the money, you may have to refinance or find another way to make the final payment.
- High chance of added debt. If you can't make the final balloon payment, you may have to take out another loan (possibly at a higher interest rate), which can add to your debt load.
What If I Can't Afford My Balloon Payment?
Unfortunately, there's no magic eight-ball for predicting the future, and you don't always know when you may fall victim to financial hardship. Sadly, that can make it difficult to make the final balloon payment.
Most of the options to pay off your balloon revolve around your credit. So you might consider getting your credit reports and checking your credit score. If you have outstanding bills or a few missed payments, clear them off your report as soon as possible. You want to put yourself in the best possible position to take advantage of the more desirable options when the payment comes due so you can avoid filing bankruptcy or going through a short sale.
Here's what you can do if you can't afford your balloon payment.
Refinance
If you're scrambling to make the balloon payment, you might consider refinancing with a fixed-rate mortgage. Keep in mind that it can take some time to qualify and close on a refinance, so start well ahead of the balloon coming due. If you can't qualify on your own, consider adding a creditworthy cosigner on your new loan.
Extend Your Mortgage
Some lenders will extend your balloon loan for a few years without changing the terms of the loan. They may increase the interest rate or ask you to partially pay down the principal, but you'll keep your home.
Trade in Your Car
You might consider trading in your car to cover the balloon payment. However, if your trade-in value isn't enough to cover the balloon, you may have to dip into your savings to come up with the funds.
Loan Modification
If you can't qualify for a loan refinance, you might consider loan modification, where your lender modifies the terms of the loan to make it easier for you to make your payments. This may include a lower interest rate, deferring payments for a number of months or extending the loan term.
Sell
There is always the option to sell your property and use the equity you've accumulated in your home to pay off the balloon payment.
Foreclose on Your Home
No one wants to see their home go into foreclosure, but if all else fails, this may be your only option. Even so, a foreclosure can often be avoided, and most lenders are willing to work with you to keep you in your home.
Should I Choose a Loan With a Balloon Payment?
When considering a balloon payment, it's best to be cautious and weigh the benefits of reduced monthly costs with the risks of owing a large lump sum at the end. But if you plan to stay in your home for a short time, a balloon payment may make sense.
Maybe your credit is poor, but you're confident you'll have the income to pay off the balloon in the future. It might also be a good choice if you expect interest rates to drop and plan to refinance your mortgage. But remember, although you're making smaller monthly payments, you still pay the same total loan amount—just a bit differently than with many other types of loans.
Balloon Payment—Is It Right For You?
A balloon payment is a suitable option in certain circumstances. But they aren't all fun and games. If you don't have the money when the balloon comes due, you could face consequences that linger for years. If you want to refinance your existing balloon payment or trade it for a fixed-rate loan but you're unsure where your credit stands, get your Experian credit report and credit score today—free.