A balloon payment loan may seem like an attractive financing option at first glance, especially if you are looking to purchase a high-value asset like a house or car but have limited funds upfront. However, such loans come with certain risks that you must consider before signing on the dotted line. This blog breaks down everything you need to know about balloon loans, including how they work, their pros and cons, and tips for managing them responsibly.
What is a Balloon Payment Loan?
A balloon payment loan lets you make smaller monthly payments for a set number of years. But when the loan period ends, you have to make one huge final payment called the "balloon payment". This balloon payment mortgage is much larger than the monthly payments you were making.
For instance, with a balloon mortgage on a house or a balloon car loan:
Monthly Payments: Your monthly payments only cover some of what you owe - the interest and part of the original loan amount.
Final Balloon: At the end of the term, the rest of what you still owe on the loan becomes the balloon payment. And you have to pay the amount all at once.
So those regular payments are buying you time before that giant final payment comes due down the road. The balloon payment is the catch with this type of loan.
The Idea Behind Balloon Loans
Financial institutions and lending companies offer balloon loans at lower interest rates so your early payments are more affordable. But they expect you to make the large balloon payment at the end in one of two ways:
Loan Refinancing: Refinancing the balance into a new loan when the original loan term expires. This transfers the outstanding amount to a new loan with new terms.
Asset Sale: Selling the asset (house, car, etc.) to repay the balance owed on the loan. Ideally, the asset value has increased, so you can pay off the loan and keep any proceeds from the sale.
In other words, balloon loans rely on leveraging anticipated increases in the value of the asset and your financial status to help you make that full balloon loan repayment later on. But what happens if things don’t go as planned?
Potential Risks of Balloon Payment Loans
While balloon loans offer lower initial repayments, they come with a few key risks to consider upfront:
1. Difficulty Refinancing a Balloon Payment
You want to refinance the balloon payment loan with a new loan, hoping you will be able to get approved for a loan again later. However, lending conditions may have changed by the time your balloon payment comes due.
For instance, financial institutions may have tightened their lending policies, or you may be unable to secure as good of an interest rate as before. If you’re unable to refinance on favourable terms, you might face a large payment that’s difficult to afford.
2. Asset Value Has Not Appreciated as Expected
Balloon loans also depend on the fact that your house, car, or other asset will be worth more by the time your loan matures. However, there is always the possibility of unexpected depreciation.
For example, if housing prices decline, you may owe more on your home than what buyers are willing to pay. This makes funding your balloon payment through a property sale challenging. The same risk applies to vehicles and other depreciating assets.
3. Overextending Yourself
While the lower initial repayments are appealing, you must critically evaluate whether you can realistically budget for that balloon payment when it falls due down the road. Make an honest assessment of your earning capability and financial discipline.
Otherwise, you may end up overextending yourself and damaging your credit profile if you are unable to make the final payment or quickly refinance the balance.
Tips for Handling Balloon Loans
Still interested in a balloon loan? Here is some guidance for managing the risks:
1. Make Payments on Time
To increase your chances of qualifying for refinancing, maintaining a good credit record is crucial. Be sure to make all your initial repayments on time and in full. Beyond boosting your credibility with lending companies, this will minimise the amount you owe later on.
2. Start Saving for the Balloon Payment
Don’t fall into a false sense of security just because your initial payments are affordable. Create an emergency fund that you can use in part or in full for handling that last big repayment. Whether you end up refinancing or selling the asset, accessible savings offer a financial safety net.
3. Weigh Up Prospective Appreciation
Carefully research historical and predicted price trends for assets like the house you want to buy. This helps ascertain the likelihood of the property or car increasing sufficiently in value to facilitate selling the asset to cover your balloon payment. If appreciation projections seem overly optimistic, reconsider opting for a balloon auto loan or mortgage.
Summary
While lower payments today are the main attraction of balloon loans, don't let tempting terms distract you from evaluating whether you can actually afford the balloon payment mortgage when due. Evaluate your employment stability, financial objectives, expenditure patterns, and retirement plans thoroughly before committing to this decision.
