There are many financing options available for mortgages. One of these options is a balloon loan. When a person has a loan to repay, a balloon loan offers an easy way to pay off the amount quickly. Balloon loans are becoming more popular in mortgage lending as the loan term is relatively short. These loans aren’t fully amortized at the end of the loan term and are different from standard loans that are entirely amortized till the end. In this post, we’ll learn more about balloon loans and their importance in real estate.
What Is a Balloon Loan?
A balloon loan is a loan that begins with fixed, regular payments for a specific term and ends with a final payment of the remaining balance. This type of loan doesn’t have full amortization of the loan amount over its term. Since there is a lack of full amortization, the borrower has to pay the remaining principal at the end of the term. These loans are suitable for those who want to pay low payments monthly with low-interest rates. With the help of these loans, borrowers can get flexible repayment options. The following are the essential terms that describe a balloon loan:
Amortization is the action of paying off or reducing the loan amount with regular monthly payments. It refers to the period when a loan is paid off until the remaining balance is zero. However, balloon loans are not fully amortized when the term ends. This means that, unlike a standard loan that has no remaining balance at the end, a balloon loan has a remaining lump sum that the borrower has to pay together in one payment. Thus, the amortization of a balloon loan is different from a standard loan.
A balloon payment is the lump sum the borrowers pay when the mortgage ends. This is a significant amount that pays off the remaining balance on the loan. This amount is larger than all the payments made during the loan term. Balloon loans have low monthly payments, but when the loan ends, the borrower has to make balloon payments to amortize the loan in a single payment. A balloon payment contains the full amount of interest accrued and the principal amount.
Bullet repayment is the full principal amount of the loan that is paid at maturity. No principal amount has been paid before bullet repayment, unlike balloon payment, which contains a small monthly payment of interest and the principal amount. When the borrower makes monthly interest payments only and not the principal amount, the payment at the end is a lump sum called bullet repayment. In many cases, the terms bullet repayment and balloon payment are used interchangeably, but there is a difference in principal between these two payments.
Balloon loans also allow borrowers to refinance an existing loan when the balloon payment is due. This way, the borrowers get more time to repay the loan if they can’t pay the huge lump sum in a single payment. Balloon loans usually have a loan term of five to seven years, but if the borrower wants to get a new loan to extend the repayment period, the option of refinancing is available. However, the borrower must qualify for the new loan with a good credit score and stable income. Plus, if the borrower refinances the balloon loan with a long-term loan, the total interest amount will be high.
Selling of Assets
If the borrower can’t make the balloon payment at the end of the loan term, selling assets is an option. For instance, the borrower can sell the home or car to pay off the remaining balance of the balloon loan. However, to do so, the borrower must ensure that the asset’s value is enough to cover the balloon payment.
When to Use Balloon Loans?
Balloon loans are risky because of the balloon payment, but they can be beneficial in certain situations. The following are the most common uses of balloon loans:
In some cases, balloon loans can be helpful in purchasing homes. Home buyers who can’t afford huge monthly payments or wish to pay per month interest only should go for balloon loans. However, only a small portion of the loan is paid off, and the larger part remains unpaid till the loan is due. This is risky as the borrower has to pay the lump sum someday. If the borrower defaults on the loan, they can lose the home.
Balloon loans can help with business expansions or for acquiring new businesses. Especially for companies that have just started and do not have enough cash flow to pay large monthly payments, these loans can be useful. With small monthly balloon loan payments, a business owner can also build credit over three to five years. Once the business has a good credit history, approval from any bank for a new loan is possible.
Construction and Land Purchase
Balloon loans can also be a temporary financing option for constructing a home. Lenders offer balloon loans with balloon payments due in two to five years, but the mortgage is calculated differently. Mortgage for balloon loans is calculated as if the borrower has a 30-year mortgage. This allows the borrower to buy land, construct a house, or refinance the loan with better rates and terms.
Balloon Loans in Commercial Real Estate
Balloon loans help in providing urgent funds for commercial real estate mortgages. The most common balloon loans used in commercial real estate are commercial real estate refinancing. These loans are used to pay back the already outstanding loan when the borrower can’t make the balloon payment. Thus, the borrower can take a new loan with a different calculation for the mortgage rates. Since the loan is not fully amortized, the monthly payments are now calculated as if the loan term is for 15 or 30 years instead of three to seven years. Commercial balloon loans allow borrowers to make a low down payment and lower monthly payments.
Commercial balloon loans allow the borrowers to make low monthly payments and down payments and lower interest rates too. These loans are mostly used when the commercial real estate investor does not have enough money to repay the due loan. In this case, refinancing is the safest option as there is no big initial down payment or high monthly repayment costs.
Balloon Loan Examples
Example 1: Let’s say a person is taking a balloon loan to purchase a house for $200,000. The interest rate is 5%, and the monthly payments are of interest only. The borrower has to pay $833.33 monthly for five years and a bullet repayment of $200,000 at maturity. In this case, you can see that the borrower has to make monthly payments for five years, but the principal amount remains the same at the end of the term. This is because the borrower was paying interest only, and the principal amount remained unchanged throughout the loan term.
Example 2: A person has two options to pay off a balloon loan. He purchased a house for $150,000 and agreed to a balloon loan with a single payment at the time of maturity. The lender offers him two options; either to pay interest only every month or to pay interest and principal amount both monthly. With the first option, the borrower has to pay $531.25 each month, which includes only interest. At the time of maturity, the borrower has to make a balloon payment of $150,000. This means that the borrower will still owe an amount equal to the price of the home after seven years when the loan term ends.
On the other hand, the borrower can pay interest and principal each month with a longer term of 17 years. The borrower can pay $531.25 per month (which is the same as the first option) but for a more extended period of 17 years. In this case, he’ll be left with a balloon payment of $75,254 at maturity. The borrower decides to choose the second option as he can make monthly payments of this amount for a longer period, and in the end, the balloon payment will be half of the property value.
Balloon Loan Frequently Asked Questions
How to Pay Off a Balloon Loan?
Borrowers have three options to pay off balloon loans. The first option to pay off a balloon loan is by making the balloon payment. The borrower must try to pay the remaining amount to get rid of the loan. If the borrower doesn’t have enough to make balloon payments, there is an option to refinance the loan. With the refinancing option, the borrower can take a new loan that is amortized over its term. The last option is to sell the home and use the proceeds to pay off the balloon loan.
What are the Disadvantages of Balloon Payments?
Balloon payments are risky because paying a considerable loan amount at maturity is very difficult for most borrowers. Plus, if the balloon loan has collateral and the borrower can’t make the balloon payment, they will lose the collateral, which in most cases is a house. Another big advantage is that the borrower mostly pays only the interest with the monthly payments, which means there’s no equity accumulation in the home.
How Is a Balloon Loan Different from Other Loans?
A balloon loan is different from other loans in terms of lenders, qualification criteria, and interest rates. The interest rates vary from lender to lender, but they are mostly higher than other loans as more risk is involved. Besides, lenders have their requirements for the balloons as they are non-qualified mortgages. Thus, there are stricter borrower requirements than other loans, such as higher credit scores and better credit histories. Small or private lenders offer balloon loans only for specific purposes, including home purchases or construction. The main difference between a balloon loan and other loans is that a balloon loan is not fully amortized at the end of the term, and there is always a remaining balance that must be paid at once.
What to Know for the Real Estate Exam
Balloon loans are partially amortized loans with a high-risk balloon payment due at maturity. These loans are called partially amortized, as the entire loan isn’t paid off before the end of the term. Thus, one large payment is known as a ‘balloon payment’, which is made at the end, that pays off the entire loan in a single payment. Balloon payment contains the remaining principal and interest that has not been paid with the regular monthly payments. These loans are more common in commercial and residential real estate. Understanding how balloon loans work is important when preparing for real estate exams. Go through these easy-to-understand real estate definitions that can help you prepare for the exam.