What is a balloon loan?
A balloon loan is essentially any loan with a large principal payment due at the end of the loan's term. A good way to illustrate how these loans work is to look at one of the more common forms of balloon loans, the balloon mortgage.
With this type of mortgage, you make fixed monthly payments for a certain period of time (3, 5, 7, or 10 years, with 5- and 7-year terms being the most prevalent). However, your monthly payments are based on the same repayment schedule (called an amortization schedule) as those for a 30-year fixed mortgage. For this reason, your fixed payments during the repayment period are relatively low. At the end of this period, the loan matures and the remaining principal balance is due as one large final payment, called the balloon payment.
For example, let's say you have a $150,000 balloon mortgage with a 4% interest rate for 5 years, after which time the remaining principal comes due. Based on a 30-year amortization schedule, your monthly mortgage payment will be $716. At the end of the 5-year term, you'll owe a remaining principal balance of $135,671. This is your balloon payment.
If you want the option of converting the balloon payment to a different type of mortgage (in case you decide to stay in the house), look for a balloon mortgage with a reset feature. The reset feature allows you to convert the balloon payment to, for example, a fixed rate mortgage at the currently prevailing rate for the remainder of the original amortization schedule.
For example, assume your balloon mortgage described earlier has a reset feature that allows you to convert the remaining principal balance to a fixed rate mortgage with a 25-year term (the remaining term of the original amortization schedule). When the balloon payment of $135,671 comes due, the prevailing rate is 6%. Exercising the reset option, your new fixed payment becomes $874 per month.
Low monthly payments may make balloon loans attractive to some borrowers, especially those with cash-flow problems that are expected to improve over time. However, borrowers who anticipate that they might refinance the balloon loan at the end of its term must be willing to accept the risk that interest rates may have gone up by that time.