A balloon payment is a large lump sum payment due at the end of a loan term typically 5 to 7 years. Your monthly payments during the term are based on a longer amortization schedule.
This means your monthly payment is lower during the loan term but the remaining balance comes due all at once when the term ends.
You must refinance sell the property or have the cash ready to pay off the balloon when it comes due.
How It Works
A balloon loan has a short term (5-7 years) but payments are calculated as if the loan were 30 years. At the end of the term the remaining balance is due in full. Example: on 00K at 6.5% your payment is ,264. After 5 years you owe about 87,000 as a balloon.
Payment Example
The monthly payment on a balloon loan is the same as a 30-year fixed loan. The difference is the term. With a 30-year fixed you have 30 years to pay. With a balloon you have 5-7 years then must pay the balance.
Risks
The biggest risk is being unable to refinance when the balloon comes due. If interest rates rise your credit changes or property values drop you may not qualify for a new loan. This can force a sale or foreclosure.
Alternatives
Alternatives to balloon loans: 30-year fixed rate loan (predictable payments no balloon), 15-year fixed (higher payments but paid off faster), or an ARM with a longer initial fixed period.
Who Uses Them
Balloon loans are used by real estate investors who plan to flip properties quickly builders who expect to sell within a few years and borrowers who expect a large lump sum of cash in the near future.
How to Avoid
To avoid balloon payment risk: choose a fully amortizing loan from the start, negotiate an extension option in your balloon note, have a clear refinance or exit plan, and maintain good credit for refinancing.