How Do Balloon Payments Work?

What are Balloon Payments and How do They Work?

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A balloon payment is a large payment due at the end of a balloon loan. A balloon loan is a short-term mortgage, often lasting between 5 and 7 years, but with a payment plan typically based on a 15 or 30-year mortgage. At the end of the mortgage, the borrower still owes the rest of the unpaid principal and is required to pay it as a lump sum. Since most borrowers can’t afford this, they typically either sell the home or refinance the balloon loan before the balloon payment is due.

Who’s the Ideal Borrower for a Balloon Loan?

A balloon loan can be a risky proposition -- but that doesn’t mean it can’t be a good choice for some borrowers. Since balloon loans typically have lower interest rates and may be easier to qualify for than most conventional loans, they can be attractive for borrowers with lower credit, or those who simply want to take advantage of the lower interest rates. Despite that, there’s no guarantee that a borrower will be able to refinance their balloon loan before the balloon payment is due -- and if they can’t refinance, convert to a fixed-rate mortgage, or sell the home, they could default on the loan.

For example, if a borrower took out a $200,000 balloon loan with a 7-year term at a 4.5% interest rate, by the end of the 7 years, they’d owe a balloon payment of more than $175,000. That’s a lot of cash to cough up at once!

Can Making Prepayments Be Beneficial to a Balloon Loan Borrower?

One of the best ways to make sure you’ll be able to refinance your balloon loan before the balloon payment is due is to make additional payments, or prepayments, on the loan. These can typically be made on a monthly basis (simply adding a certain amount to your mortgage payment) or on a once-annual basis.

That way, you’ll have a lot more home equity when it comes time to refinance, meaning that your loan will probably have a lower LTV ratio, making it less risky for lenders.

The main thing to watch out for here is prepayment penalties, which are surprisingly common in balloon loans. If your balloon loan has prepayment penalties, it might be a good time to start looking for another loan product. The reason? These penalties might also kick in if you want to refinance your home or sell your home too many years before the balloon payment is due.

For example, you could get charged if you wanted to sell or refinance your home in four years into a seven-year balloon mortgage. That could severely limit your options -- and make it much more difficult for you to emerge from your balloon loan financially unscathed.

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