A balloon payment is a payoff option on a loan that allows you to make a larger-than-usual lump sum payment at the end of the loan’s term. This, in turn, can lower your earlier payments.
A balloon payment structure is sometimes offered on home mortgages, auto loans, and business loans. Is it a good deal for the borrower? Sometimes. However, balloon loans also come with some significant risks.
Read on for a closer look at how balloon loans work, when you might consider getting one, and alternative ways to reduce your loan payments.
Key Points
• A balloon payment allows borrowers to benefit from lower monthly payments during the loan term, as the larger balloon payment is deferred until the end.
• Balloon loans are often used for short-term financing, with the expectation of refinancing or selling assets before the payment is due.
• Balloon payments are most commonly found in commercial real estate, auto financing, and some business loans.
• Balloon financing is risky because if you can’t come up with the large, final payment, it could lead to further debt or default and have a negative impact on your credit.
What Is a Balloon Payment?
A balloon payment is just like its name suggests – it balloons, or inflates, at the end of the loan. With this set up, you typically make regular (often monthly) payments over the term of the loan, then pay a significantly larger sum at the end of the loan’s term.
Balloon payments are most commonly used for small business loans, though they are also available on some auto loans and mortgages.
How Does a Balloon Payment Work?
A balloon payment loan works just like any other installment loan. The only difference is that the amount of the final payment is usually substantially higher than the previous payments.
The balloon payment may simply be a weighted payment amount. In many cases, though, the installment payments go towards interest only and the balloon payment covers the entire principle. The interest you pay each month is typically a fixed amount, since the principal balance does not change.
While balloon payments allow you to reduce the size of your regular loan payments, these loans tend to come with shorter terms than traditional installment loans, which means the final, large payment may be due after a few months or years.
Balloon loans represent an increased risk to the lender, as they must trust that you’ll be able to make the final payment at the end of the loan. As a result, they can be more difficult to qualify for than traditional loans. Typically, lenders will only offer a balloon payment to individuals and businesses with excellent credit, solid cash savings, and stable income streams.
Examples of Balloon Payments
Balloon payments are common in real estate, auto financing, and business loans. Below are examples of balloon payment scenarios.
Mortgage Loans
A balloon mortgage allows you to get a lower monthly payment than you would with a traditional mortgage. For example, an interest-only mortgage loan is a type of balloon loan that allows you to defer paying down principal for five to 10 years and instead make interest-only payments.
In some cases, borrowers will try to sell the home or refinance before the balloon payment deadline. But this approach isn’t without risk. If the value of your property goes down or you experience a job loss or other financial hardship, you may not be able to sell or refinance before the balloon payment comes due. If you can’t make the payment, you risk losing your home to foreclosure.
However, if you plan only to live in a home for a few years or you’re planning to flip the property, a balloon mortgage might be worth considering. You could then use the proceeds from the sale of the home to make the balloon payment.
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Auto Loans
Though not common, balloon payments are sometimes offered by auto lenders. Like other balloon loans, this type of auto financing allows you to pay less at the beginning, then make a much larger final payment.
A balloon auto loan might be helpful for someone who has an urgent need to purchase a vehicle (perhaps to earn money), but may not have the current income to support higher monthly payments. Once the borrower has a steady income, they would be able to make the balloon payment.
Just as with other types of balloon loans, however, this type of car loan comes with risks. If your income doesn’t increase, you may not be able to pay the lump sum when it comes due. If you skip your balloon payment, your lender could repossess your vehicle, send you to collections, or both. Either way, you risk damaging your credit, which could make it difficult for you to get financing in the future.
Business Loans
A balloon business loan can be an attractive option to a business with a short-term financial need or that is looking to purchase commercial real estate. It enables you to get the capital you need to grow your business while you wait for that big payday from a customer.
For example, a balloon business loan might work better than other types of small business loans if you’re looking to purchase new office, warehouse, or retail space before selling your old space, since the delayed payment set up can give you time to sell the old property.
Of course, balloon loans pose the same risks to businesses as to consumers. If your company doesn’t have a guaranteed source of income, it can be dicey to take on a small business loan that demands a large lump sum payment. While refinancing may be an option to get out of a balloon payment, there’s no guarantee that a lender will grant you a new loan.
If you’re unable to make your balloon payment, the lender may begin legal action to collect their money, which can include seizing business or personal assets. And they may report negative information to credit reporting agencies, causing damage to your business credit and possibly your personal credit, as well.
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Advantages and Disadvantages of Balloon Payments
As with all types of financing, balloon payments come with pros and cons. Here’s a look at how they stack up.
| Advantages of Balloon Payments | Disadvantages of Balloon Payments |
|---|---|
| Lower initial payments than you’d get with a traditional installment loan | If used to purchase an asset, you may build little to no equity despite regular payments |
| Frees up money you can put towards other uses | Have to come up with high final payment |
| Can work well if you expect your income or revenues to increase over time | Could lead to further debt or default |
Advantages of Balloon Payments
One of the biggest advantages of balloon payments is the lower initial payment amounts. During the fixed period, monthly payments are generally smaller than they would be for a traditional installment loan, which could be helpful if you have limited income or low annual business revenue.
Smaller upfront payment requirements can also allow you to borrow more than you would otherwise be able to manage. Also, if you own a business, the lower payments can free up capital for other uses that could pay off by the time the balloon payment is due. A delayed large payment could also mesh well if you expect your salary or business revenues to increase over time.
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Disadvantages of Balloon Payments
If you use a balloon loan to purchase an asset, such as a home or a car, you may build little to no equity in that asset despite making consistent payments. This is especially true if your installment payments are interest only. Lack of equity can make it difficult to refinance the loan.
These loans also tend to be riskier than traditional loans — both for individuals and businesses. If you can’t come up with the balloon payment at the end, you may need to refinance, potentially at a higher annual percentage rate (APR). If you aren’t able to refinance, you could end up defaulting on the loan.
How to Avoid a Balloon Payment
To avoid balloon payments, consider choosing traditional fixed-rate or fully amortizing loans. These options spread payments evenly over the loan term, eliminating large end-of-term balances.
If you’re already in a balloon payment loan, refinancing before the balloon is due can help you convert the loan into a more manageable payment plan. Additionally, making extra payments toward the principal throughout the loan term can reduce the amount owed at the end.
4 Ways to Get Rid of a Balloon Payment
If you aren’t ready to make a balloon payment when it comes due, you may have some options. Here are four ways to potentially get rid of a balloon payment.
1. Extend the Loan
If you need more time to come up with the balloon payment, you may be able to negotiate an extension with your lender.
Similar to refinancing, an extension changes the terms of your original loan. With an extension, however, you typically don’t receive an entirely new deal. You’ll just be changing the date of the balloon payment. Keep in mind that there may be fees involved and you can typically only get a short-term extension.
2. Sell the Asset
If you used the balloon loan to buy an asset, such as a property or a car, you may be able to sell that asset to come up with the cash needed for the balloon payment.
3. Pay the Principal Upfront
One effective way to get rid of or reduce a balloon payment is to increase your installment payments so that they include some of (or more of) the principal. This can also lower your interest costs. Just check to make sure there aren’t any prepayment penalties or fees.
4. Refinance the Loan
Another way to avoid making a balloon payment is to refinance the loan with a different lender before it’s due. You could then use the proceeds from the new loan to make the balloon payment. Moving forward, you would make payments on your new loan.
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Balloon Payment vs Adjustable-Rate Mortgage (ARM)
You’re likely considering a balloon mortgage because you want the luxury of lower payments. However, you might be able to achieve a similar result with an adjustable-rate mortgage (ARM).
With an ARM, you typically pay a predetermined APR for a period of one to five years. Usually, this rate is lower than what you would get with a comparable fixed-rate mortgage. Unlike balloon loans, though, the entire balance of an ARM doesn’t come due at once.
Instead, the interest rate and payments adjust throughout the loan term. After the guaranteed rate period ends, the interest rate is recalculated based on current market conditions, which means it could end up being higher or lower than the initial rate. Depending on the loan agreement, the APR may adjust multiple times over the course of the loan.
An ARM can give you lower monthly payments, at least for the fixed period of the loan, but comes with risks. If interest rates rise, you’ll likely end up paying more in interest over the life of the loan than you would have if you had taken out a fixed-rate mortgage. However, the lower initial monthly payment may be worth it if you’re stretching to afford the home and feel confident that your income is on the rise.
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Other Ways to Reduce Monthly Loan Payments
Getting a balloon payment is not the only way to lower your initial payments on a loan. Here are some other strategies you may want to consider.
Large Down Payment
The larger your down payment on a loan, the less you will need to borrow, and the less you borrow, generally the lower your monthly payment will be. A bigger down payment can also result in a lower APR, which could further lower your monthly payments.
Refinancing
You may be able to lower your payments on an existing loan by refinancing, which involves swapping your existing loan for a new one with more favorable terms. If you can get a new loan with a lower APR, your monthly payments will decrease, as will the total cost of your loan.
Longer Loan Term
Another way to pay less each month on a loan is to choose a longer term. If you already have a loan, you may be able to requalify for refinancing that extends your loan repayment term. Just be aware that a longer loan term means accumulating more interest charges over time. APRs on long-term loans can also be higher. As a result, this approach will typically increase the total cost of your loan.
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The Takeaway
Balloon loans allow borrowers to have lower payments at the beginning of a loan in exchange for a larger (balloon) payment at the end of the loan’s term.
Whether you’re a consumer or a business owner, it’s important to remember that balloon loans aren’t actually more affordable — they simply spread the total cost out in a different way.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
How exactly do balloon payments work?
A balloon payment loan works in a similar way to other types of installment loans. You receive the proceeds of the loan up front then make payments according to a fixed schedule. The only difference is that the initial payments are lower than what you would pay with a traditional installment loan, and the final (balloon) payment is higher.
Are balloon payments a good idea generally?
Balloon loans tend to be risky due to the large payments that are due at the end of the loan term. However, this type of financing might be useful for some borrowers, such as a business that has an immediate financing need and a predictable future income.
Why would you want a balloon payment?
You may want a balloon payment because it allows for lower monthly payments throughout the loan term, which can improve short-term cash flow. It’s beneficial if you expect a future increase in income or a lump sum (e.g., from a sale or investment), allowing you to manage finances now and pay off the balance later.
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