What is a Balloon Payment?

Robinhood Learn
Democratize finance for all. Our writers’ work has appeared in The Wall Street Journal, Forbes, the Chicago Tribune, Quartz, the San Francisco Chronicle, and more.
Definition:

A balloon payment is one that you make at the end of a loan term that’s larger than a normal payment.

🤔 Understanding a balloon payment

A balloon payment occurs most often in the case of mortgages. When you take out a loan with a balloon payment, you may have lower payments in the years leading up to the final one. Then you end up owing one extra-large payment at the end. Balloon payments aren’t feasible for many consumers, as they can range from twice the normal loan payment to tens of thousands of dollars. There’s always the risk that the borrower won’t be able to afford that large payment when it comes due. For that reason, balloon loans are often better suited to business loans and commercial lending.

Example

One situation when a balloon payment might make sense is when you’re flipping a house. Suppose you’re an investor who buys fixer-upper houses, renovates them, and then turns around and sells them for a hefty profit. You know you aren’t going to own the house for more than a couple of years. You decide it makes sense to take out a loan with smaller monthly payments while you put money into renovating the house. Then, when you sell the home for more money, you can pay off the whole loan.

Takeaway

A balloon payment is like saving all of your weekend chores for Sunday evening...

Suppose you’re doing some spring cleaning around the house. You make a big list of all the things you need to get done by the end of the week, but when Sunday evening rolls around, you haven’t finished most of them. You find yourself having to get in all the chores in the last few hours of your weekend. Balloon payments are similar, where you’re saving a big chunk of your payments for the very end, when you’ll owe them all at once.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.
Sign up for Robinhood
Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

Tell me more…

What is a balloon payment?

A balloon payment is a single payment you make on a loan that’s significantly larger than a normal one. Balloon payments often take place at the end of a loan to pay off the rest of the amount you owe. They’re often at least twice as much as a normal one, though they can range up to tens of thousands of dollars.

How do balloon loans work?

When you take out a balloon loan (which is generally a mortgage or a car loan), the monthly payments you make throughout the life of the loan aren’t enough to pay off the balance. This type of mortgage loan often has a life of five to seven years, even though the payment schedule is based on a loan term of 30 years (though with a lower interest rate than a typical 30-year mortgage).

After making smaller payments throughout the loan, you’ll make one large balloon payment at the end, which can be many times the normal monthly payment. These balloon loans most commonly take place in the case of commercial loans, where an investor plans to either resell the property before the end of the loan or refinance to a traditional mortgage.

What happens if you can’t afford your mortgage balloon payment?

Ideally, homebuyers would set aside money throughout the life of their loan so when their balloon payment comes due, they’ve got the money to pay it. But there are some cases where this doesn’t happen.

If you can’t make your balloon payment, you may be able to work out a payment plan with your lender. You can also see if the lender is willing to modify your loan, which may change your payment amounts for a period of time. Finally, you may need to either sell the home or relinquish ownership to the lender to cover the debt.

Regardless of which choice you believe is right for you, you should reach out to your loan servicer as soon as you know you won’t be able to pay. The last thing you want is to miss a payment without having communicated to your lender ahead of time. Doing so can lead to negative marks on your credit score, which can make it more difficult to borrow money in the future. In an even worse case scenario, failing to make your mortgage payments can cause your lender to take actions toward foreclosure.

How do you get rid of a balloon payment?

If you currently have a balloon mortgage, you might be wondering how to get rid of an upcoming balloon payment. Two options are to either sell the home before you reach the balloon payment or refinance your loan.

How do you refinance a balloon loan?

First, know that refinancing will require some out-of-pocket costs. Expect to pay an application fee, closing costs, and potentially a fee for a lower interest rate (aka “points”). If your current mortgage has a prepayment penalty, then you’ll have to account for that as well.

Next, consider the type of mortgage you want. Common alternatives include a 15 or 30-year mortgage with a fixed rate, which means your interest rate stays the same for the whole life of the loan. You may also consider an adjustable rate mortgage, where the interest rate changes periodically according to an index rate.

If you’re interested in refinancing your balloon loan and have an idea of what type of mortgage you want to refinance to, meet with your lender to figure out the next steps.

What are the differences between balloon payments and adjustable-rate mortgages?

A balloon mortgage is one that has lower payments throughout the life of the loan in exchange for one lump sum payment at the very end. Balloon payments are often at least twice as much as a normal mortgage payment but can be as high as tens of thousands of dollars.

An adjustable rate mortgage (ARM) is also one where the payment amounts may vary at different times throughout the loan, but in a very different way than a balloon payment mortgage. An ARM generally starts with an interest rate lower than the current rate for fixed-rate mortgages. For a period generally ranging from one month to five years, your rate will stay the same.

After the initial fixed-rate period, the interest rate on ARMs can vary. The rates on these loans are tied to a particular rate index such as the current rate on a 1-year Treasury security or the London Interbank Offered Rate (LIBOR), which is the rate at which banks are willing to lend each other money. ARMs also have a margin, which is the amount above the index rate that your rate sits at. So if the index rate is 1.25% and your loan has a margin of 3%, then your interest rate is 4.25%.

Like balloon mortgages, ARMs may result in significantly higher payments toward the end of the loan than at the beginning. But there are guarantees in place to make sure those payments don’t get too out of control. The rate on an ARM can only increase by a predetermined amount over the life of the loan.

The other thing to remember is that ARM rates are tied to an index. So while there’s certainly the risk of your rate increasing quite a bit, there’s also the chance of your rate going down if the index rate goes down.

What are the advantages and disadvantages of a balloon mortgage?

Balloon mortgages offer the significant advantage of low monthly payments in the early years with a lower interest rate. Many lenders also let borrowers refinance the loan later, meaning you might be able to avoid a balloon payment altogether.

Balloon mortgages aren’t for everyone, though, and come with some serious risks. First, a balloon mortgage means one large payment at the end of the term. Even borrowers who are aware of this upfront might find themselves caught off guard by it. You also run the risk of not being able to refinance, even if that was originally your plan.

Finally, falling property values might throw a wrench in your plan to pay off your loan. During the real estate boom in the early 2000s, homeowners took out balloon mortgages thinking they’d either start making a lot more money or sell the house later. Then the mortgage crisis hit, and people were stuck with mortgages worth a lot more than their homes.

Is a balloon loan a good idea?

There are clearly advantages to a balloon loan (specifically, much lower payments earlier in the loan). But given the risks related to the sizable payment you’ll have to make at the end, these loans aren’t for everyone.

These home loans may be ideal for someone buying an investment property. If you plan to buy a home to renovate and resell or to renovate and rent out, then you might feel confident you’ll be able to pay off the mortgage prior to the end of the loan. And even if you end up keeping the home, you might be able to refinance to a longer-term loan.

A word of caution: If you go into a balloon mortgage assuming that you’ll refinance later, give it some serious thought. You may find yourself unable to refinance down the road. You may also end up with unfavorable loan terms, especially if interest rates are high at the time you refinance.

What are the qualifications for a balloon payment?

The Truth in Lending Act is a federal law that protects consumers against unfair credit practices. The Bureau of Consumer Financial Protection enforces the law with the administrative rule Regulation Z. The rule prevents lenders from giving mortgages to borrowers they don’t believe will be able to make the payments.

For balloon mortgages, lenders have to consider whether they believe borrowers can make the balloon payment. This law helps to prevent people from taking out balloon mortgages when they probably shouldn’t be.

To apply for a balloon mortgage, you’ll share information such as your income, credit score, and monthly debt-to-income ratio (the percentage of your monthly income going toward debt). If the lender doesn’t think you’ll be able to make your balloon payment, it’ll likely deny your application.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

1269066

Related Articles

What is a Mortgagee?
Updated December 15, 2020

You May Also Like

The 3-minute newsletter with fresh takes on the financial news you need to start your day.
The 3-minute newsletter with fresh takes on the financial news you need to start your day.


© 2021 Robinhood. All rights reserved.

This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Robinhood Financial LLC (member SIPC), is a registered broker dealer. Robinhood Securities, LLC (member SIPC), provides brokerage clearing services. Robinhood Crypto, LLC provides crypto currency trading. All are subsidiaries of Robinhood Markets, Inc. (‘Robinhood’).

1771482