Balloon Loans and Payments Explained
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Many amortized loans — including some used to acquire apartment properties — are structured with relatively short terms in which only a portion of the principal amount is amortized over that period. When a loan like this arrives at its maturity date, there is typically a large sum still due to be paid by the borrower that accounts for the portion of principal that wasn’t amortized over the loan term. Because of the large size of the payment due at the end of the loan term, the sum is often referred to as a balloon payment, and the financial instrument it is attached to is often called a balloon loan.
With many balloon loans, the borrower initially makes monthly installments at a set interest rate for a set number of years. When this initial period comes to an end, one of two things can happen. In some cases, the loan resets, causing the balloon payment to be rolled into a new (or continuing) amortized mortgage. The new, reset mortgage adopts the prevailing interest rate of the market at the time the initial period ended. Balloon mortgages do not reset automatically, however, instead depending on several factors like whether or not the borrower’s income remains consistent and whether payments on the note were made on time each month. Should any factor prevent a balloon loan from resetting, the borrower is then responsible for making the balloon payment.
For an investor, planning for a balloon payment is critical. After all, in most cases, a balloon payment is at least double the value of the monthly installment amount — and can stretch in value to tens or even hundreds of thousands of dollars. In order to avoid having to pay such a hefty amount in one installment, many investors choose instead to either sell the asset or refinance the loan before the balloon payment becomes due.
Related Questions
What is a balloon loan?
A balloon loan is a type of loan that lets you reduce monthly costs for a set period of time, followed by one large payment to pay off the remaining balance at the end of the term. Businesses generally use balloon loans for short-term or commercial real estate financing. Because the large payment at the end is high-risk for lenders, business owners are typically required to have excellent credit to qualify.
For an investor, planning for a balloon payment is critical. After all, in most cases, a balloon payment is at least double the value of the monthly installment amount — and can stretch in value to tens or even hundreds of thousands of dollars. In order to avoid having to pay such a hefty amount in one installment, many investors choose instead to either sell the asset or refinance the loan before the balloon payment becomes due.
To calculate the size and scope of your balloon payment, you can use our calculator.
What are the advantages of a balloon loan?
A balloon loan is a type of loan that lets you reduce monthly costs for a set period of time, followed by one large payment to pay off the remaining balance at the end of the term. Businesses generally use balloon loans for short-term or commercial real estate financing. The main advantage of a balloon loan is that it allows for smaller monthly payments than would otherwise be possible. This can help improve cash flows and the bottom line. Additionally, balloon loans can be used to negotiate better terms with lenders, such as lower interest rates.
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What are the disadvantages of a balloon loan?
The main disadvantage of a balloon loan is that it requires a large payment at the end of the loan term. This payment is known as a balloon payment and is usually much larger than the regular payments made throughout the loan term. Additionally, balloon loans often have higher interest rates than traditional loans, and they can be difficult to refinance. Finally, most balloon loans are non-recourse, meaning that if you are unable to make payments, the lender cannot tap into your personal assets or income streams. Only the property is on the hook.
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What are the different types of balloon loans?
Balloon loans are typically structured with relatively short terms in which only a portion of the principal amount is amortized over that period. There are two main types of balloon loans:
- Reset Balloon Loans: These loans reset at the end of the initial period, causing the balloon payment to be rolled into a new (or continuing) amortized mortgage. The new, reset mortgage adopts the prevailing interest rate of the market at the time the initial period ended.
- Non-Reset Balloon Loans: These loans do not reset automatically, instead depending on several factors like whether or not the borrower’s income remains consistent and whether payments on the note were made on time each month. Should any factor prevent a balloon loan from resetting, the borrower is then responsible for making the balloon payment.
Source: Apartment.Loans
What are the payment options for a balloon loan?
The payment options for a balloon loan depend on the borrower's unique circumstances. One option is to negotiate with the lender to extend the loan's term, which will delay the balloon payment and reduce the total amount due. Another option is to refinance the loan, which can help to reduce the monthly payments and the total amount due. Finally, a borrower can also pay off the loan in full before the balloon payment is due.