What Is a Balloon Payment?
A balloon payment is a large one-time payment that is due at the end of a loan. Mortgages with loan payments usually have lower payments in the years leading up to the balloon payment. This is because the loan only requires that borrowers pay interest for the first few years, allowing the balance to grow. Balloon loans are not nearly as common as they were in the past, but they are still offered to well-qualified borrowers.
How a Balloon Payment Loan Works
A balloon mortgage does not fully amortize over the life of the loan. This means there is a balance remaining when the loan is due. This happens because a balloon loan requires interest-only payments for the first few years of the loan. With a standard loan, every payment goes to interest and principal to reduce the balance of the loan. Interest-only payments can dramatically reduce the monthly payments, but the interest will continue to accumulate.
Balloon loans are most often found in commercial real estate loans than residential loans, although some home mortgages still have balloon payments. The typical balloon payment is around 2x the average monthly payment on the mortgage, but it may be tens of thousands.
When a Balloon Payment Makes Sense
With a balloon loan, your monthly payments are lower in the initial stage of your mortgage. Because this feature is considered a higher risk, it’s usually only available to borrowers with excellent credit and stable income.
The ability to finance a home purchase with lower monthly payments can be a big advantage to qualified buyers. Most borrowers do not even make the balloon payment when the term ends. If you qualify, you can refinance to avoid paying the lump sum or sell the home. This also makes balloon loans attractive to buyers who do not plan to live in the home for very long.
Drawbacks of a Balloon Loan
While a balloon payment can make sense for some borrowers, it’s not the right choice for everyone. With most balloon loans, a lump sum balloon payment is due 3-7 years after taking out the loan.
Because balloon loans only require interest payments for the first several years, you will not build equity if you do not make additional payments toward principal.
Balloon Payments Aren’t Allowed with Qualified Mortgages
Qualified mortgages are loans with certain stable features that are designed to help consumers afford their mortgages. When a lender offers a Qualified Mortgage, it means the lender followed the federal ability-to-repay rule.
Qualified Mortgages do not allow excessive upfront fees and points and limit how much income can go toward debt. They also ban certain risky loan features like negative amortization and balloon payments. In exchange for meeting these qualifications, lenders get better legal protection.