Balloon Payments & Balloon Loans
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Many amortized loans, like many of the ones used to acquire commercial real estate properties, are originated with short-term lengths, where only a portion of the principal amount is amortized over that period. Upon reaching the maturity date with these kinds of loans, there is usually a large portion of the debt still left to be paid by the borrower, accounting for the portion of the principal that wasn’t amortized over the life of the loan. The amount that a borrower has to pay at the end of such a loan is larger than the loan’s monthly installments — that sum is called a balloon payment. Loans with a lump sum at the end are known as balloon loans.
How Do Balloon Loans Work?
In most cases, balloon loans start off pretty similar to fixed-rate conventional loans — the borrower must make monthly installments at a set interest rate for a set period of time. At the end of this initial period, however, one of two things can happen. In some cases when applicable, the loan is reset. This causes the balloon payment to be rolled into a new (or continuing) amortized mortgage, not unlike when a borrower refinances an existing loan. After this reset, the new mortgage adopts the prevailing interest rate of the market at the time that the initial period ended.
This reset is not an automatic feature shared by all balloon loans, however. In actuality, whether or not the loan can be reset depends on several factors like if the borrower’s income has proven to be consistent and whether the debt has been paid on time every month. In the event that the lender is dissatisfied after a careful financial analysis of the borrower, they may prevent the balloon loan from resetting — leaving the borrower responsible for making the balloon payment.
Related Questions
What is a balloon payment?
A balloon payment is the natural consequence of having a loan with a term shorter than its amortization period. It is a large, lump-sum payment made at the end of a loan's term. It is typically made in conjunction with a loan that has a shorter term than the borrower's overall repayment timeline, and it is often used to lower the borrower's monthly payments during the loan's term.
The balloon payment size is determined by the amount of the loan's remaining principal balance, and it must be paid in full for the borrower to satisfy the loan.
For more information, you can read Investopedia's article on balloon payments.
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.
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 more information, please see The Internet's 9 Best Commercial Loan Calculators and Balloon Loans and Payments Explained.
What are the advantages of a balloon loan?
A balloon loan can be beneficial for businesses that need short-term or commercial real estate financing. The main advantage of a balloon loan is that it allows for significantly smaller payments than would otherwise be possible. This can be beneficial for businesses that need to conserve cash flow. Additionally, balloon loans can be beneficial for businesses that are expecting to receive a large influx of cash in the near future, such as from a sale or other investment.
For more information, you can check out The Internet's 9 Best Commercial Loan Calculators and 5 Methods for Handling Balloon Payments.
What are the disadvantages of a balloon loan?
The disadvantages of a balloon loan include:
- Highest rates.
- Highest closing costs.
- Short period with balloon payment.
- Risk of losing property for a fairly small loan amount.
- Full recourse.
Defaulting on the loan is also an option, but it is the worst option and can be immensely damaging to your commercial real estate investment career. Most loans with balloon payments are non-recourse, meaning the lender cannot tap into your personal assets or income streams.
What are the risks associated with a balloon loan?
The main risk associated with a balloon loan is that the borrower may not be able to make the balloon payment when it is due. Defaulting on a balloon loan can be immensely damaging to your commercial real estate investment career, as significantly fewer lenders will consider extending financing to a borrower that has defaulted. This means any financing you get in the future will be far more expensive — and bear far poorer terms — than it would otherwise. Additionally, most loans with balloon payments are non-recourse, meaning the lender cannot tap into your personal assets or income streams. Only the property is on the hook. For more information on non-recourse financing, see this article.
What are the alternatives to a balloon loan?
The alternatives to a balloon loan are to refinance the loan, extend the loan term, pay off the loan in full, or default on the loan. Refinancing the loan means taking out a new loan to pay off the existing loan. Extending the loan term means negotiating with the lender to extend the loan term, which can help reduce the size of the balloon payment. Paying off the loan in full means having the funds available to pay off the loan in full before the balloon payment is due. Defaulting on the loan is the worst option, as it can be immensely damaging to your commercial real estate investment career.
For more information, see 5 Methods for Handling Balloon Payments and Is Non-Recourse Financing Right for You?.