What are Balloon Payments?
Balloons are wonderful, aren’t they? While adults may understand that balloons float because they are filled with a gas that is lighter than air, to children, balloons might as well be magic. Children love balloons, even after they realize they won’t be able to fly with them no matter how many they hold at once.
Unfortunately, as we age, not only do we begin to understand how balloons work, but it may come to light that there are some dangerous balloons out there. These dangerous balloons include hot air balloons and balloon payments. However, today we will only be talking about one of these: balloon payments.
A traditional amortized or installment loan is structured so the borrower pays off part of the principal (or original amount borrowed) and interest in regular, consistent amounts. That means the borrower will be able to pay off the entire loan in a known time frame without any surprises. Balloon loans are different than traditional amortized loans.
“Instead of fixed monthly borrowing payments that gradually eliminate debts and establish credit, balloon loans are paid off with large single payments when a loan has reached maturity,” warned Beverly Friedmann, content manager for ReviewingThis.
These are called “balloon payments” because the last payment is inflated relative to the previous payments the borrower has been making—significantly inflated, as Friedmann explained. “Balloon payments are typically at least twice the amount of a loan's prior regular payments,” she said. “They can apply to mortgages, business financing, commercial loans, and other types of amortized loans (i.e. auto payments).”
It is vital that you know if you will be facing a balloon payment at the end of your loan payments so you can have enough money set aside to pay for the increase. However, even if you did have the foresight to set aside money, you might still end up in trouble.
“The greatest risk with balloon mortgages is that the property goes down in value, rather than appreciating,” said Brian Davis, co-founder of SparkRental.com. “In that case, the borrower often can’t refinance or sell without taking a loss.”
While mortgages with balloon payments may have better initial rates, the risks should not be underestimated.
Consider your options
Brain Davis made it quite clear that you are going to want to avoid balloon payments if possible: “Unless borrowers know for a fact that they will be selling the property within the balloon period, I recommend they avoid balloon mortgages and take out a 15- or 30-year fixed mortgage.”
What other options could you consider? Here are a few possibilities.
Selling your home: “Selling whatever property was loaned (i.e. a home, car) is another option prior to an impending balloon payment if you don't have the funds to cover it,” Friedmann advised. “In the case of homeownership, this is often to avoid foreclosure and/or filing for bankruptcy.” However, the housing market may help to determine if this is a wise option. “This can be a difficult process if the housing market has changed since you invested in your property, and you may find yourself making less than what you paid into it in the first place.”
Refinancing: “If you're in good financial and credit standing, you may decide to refinance your balloon payment by taking out another loan,” Friedmann said. “This new loan may add several years to your repayment structure plan, allowing you some time to restructure your finances into a more feasible and longer term payback system. You might even refinance a home loan into a long term mortgage. The only drawbacks to refinancing is that your interest rates might rise, and you won't be able to utilize this option without good credit, income, and assets.”
Wait on buying: It might be worth holding off on buying a home for now. While you may have been told that renting is equivalent to throwing your money away, this is not necessarily the case. Homeownership comes with many unexpected costs, so if you are not certain that you will be staying in the home for a long time, then it is probably smart to rent for now.
The American Dream
Owning a home has long been part of the American Dream, and there are a lot of mortgage brokers who are willing to take advantage of the desire for a home to stick you into a loan you can not manage. Always do your research and consult whichever experts you can before you lock yourself into any financial commitment, especially if it is as large and lengthy as a mortgage.
G. Brian Davis is a landlord, personal finance writer, and co-founder of SparkRental.com, which provides free video courses and rental investing tools for landlords. He spends most of the year overseas, splitting his time between Abu Dhabi, Europe, and his hometown of Baltimore.