Financial Word of the Day: Balloon Payment

Some loans end with a nice, predictable final payment. Others end with a balloon. And unfortunately, we’re not talking about the kind that comes with cake and ice cream.

What Is a Balloon Payment?

A balloon payment is a large, lump-sum payment due at the end of a loan term.

With a traditional fully amortizing loan, your monthly payments are calculated so that the entire loan balance is gradually paid off by the end of the loan. With a balloon loan, your regular payments may be calculated using a longer repayment schedule, but the actual loan term ends much sooner.

The remaining balance then becomes due all at once. That final large payment is the balloon payment.

Here’s an Example of a Balloon Payment

Imagine you borrow $200,000 to purchase a property.

Your monthly payments might be calculated as though you're paying the loan back over 25 or 30 years, which keeps the monthly payment relatively manageable. But the loan itself might have only a five-year term.

At the end of those five years, you haven't paid off anywhere close to the entire $200,000. Whatever principal remains could become due immediately.

You might have a balance of $175,000 or more that suddenly needs to be paid, refinanced, or otherwise dealt with. That's the balloon.

Why Would Anyone Want a Balloon Payment?

Balloon loans aren't necessarily bad. In fact, they're fairly common in certain types of commercial real estate and business financing.

They can allow borrowers to receive lower monthly payments while using their available cash for other investments or business opportunities.

An investor might purchase a property using a five-year balloon loan with the expectation that the property will increase in value, generate cash flow, and eventually be refinanced into another loan.

The strategy can work very well. Until it doesn't.

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The Balloon Payment Risk You Need to Understand

The biggest danger isn't necessarily the balloon payment itself. It's assuming you'll easily be able to refinance when the balloon payment arrives.

Imagine taking out a loan today and planning to refinance it five years from now.

• What will interest rates be then?

• What will the property be worth?

• Will banks still be lending aggressively?

• What will your income or credit look like?

Nobody knows.

If property values fall or interest rates rise significantly, refinancing could become much more difficult, or much more expensive.

That's why financially savvy borrowers don't simply ask: “What's my monthly payment?”

They also ask: “When does this loan mature, and is there a balloon payment?”

That second question could save you from a very expensive surprise.

Using "Balloon Payment" in Conversation

Here's how you might use today's term in conversation: “The monthly payment looks affordable, but I want to know whether the loan has a balloon payment and how much principal will still be outstanding when it comes due.”

That's a smart question.

Final Word on Balloon Payments

Remember: A low monthly payment doesn't necessarily mean you have a great loan. Always understand how the loan ends.

Because when it comes to borrowing money, you don't want a $150,000 balloon floating into the room that nobody bothered to tell you about.

Learn the language. Understand the numbers. Make smarter money decisions.