how a balloon loan works
mortgages are the loans most commonly associated with balloon payments balloon mortgages typically have short terms ranging from five to seven years however the monthly payments through this short term are not set up to cover the entire loan repayment instead the monthly payments are calculated as if the loan is a traditional 30 year mortgage 23that said the payment structure for a balloon loan is very different from a traditional loan at the end of the five to seven year term the borrower has paid off only a fraction of the principal balance and the rest is then due all at once at that point the borrower may sell the home to cover the balloon payment or take out a new loan to cover the payment effectively refinancing the mortgage alternatively they may make the payment in cash defaulting on a balloon loan will negatively impact the borrower s credit rating 4example of a balloon loanlet s say a person takes out a 200 000 mortgage with a seven year term and a 4 5 interest rate their monthly payment for seven years is 1 013 at the end of the seven year term they owe a 175 066 balloon payment special considerations for a balloon loansome balloon loans such as a five year balloon mortgage have a reset option at the end of the five year term that allows for a resetting of the interest rate based on current interest rates and a recalculation of the amortization schedule based on a new term if a balloon loan does not have a reset option the lender expects the borrower to pay the balloon payment or refinance the loan before the end of the original term if interest rates are very high and in the case of a mortgage the borrower doesn t plan to keep the home for long a balloon loan could make sense but it comes with high risk when the loan term is up the borrower will need financial discipline to save enough money for the balloon payment what s more if interest rates are low or are expected to rise they may well be higher when the borrower needs to refinance pros and cons of balloon loansfor some buyers a balloon loan has clear advantages but having a loan with a giant balloon payment of most or all of the principal also has clear disadvantages there s also an underlying risk of opting for a balloon loan it s easy to be tricked by the small size of the original interest only or mostly monthly payment into borrowing more money than an individual can comfortably afford to borrow that is also a potential road to financial ruin 