A balloon loan is a type of loan that does not fully amortize over its term. Because of this, at the end of the term, the borrower has to pay the remaining principal balance of the loan. Balloon loans can be attractive, not just because of the name, but also because they usually have lower interest rates than longer term loans.
How does a balloon loan work?
Usually, balloon loans are associated with mortgages. These balloon mortgages have short terms, between five and seven years.
The monthly payments for a balloon mortgage aren’t set up to cover the entire amount of the loan. Instead, they are calculated as if the loan is a 30-year mortgage. However, at the end of the term, the borrower has to pay the remaining amount all at once. Or, if this is not possible, to refinance the loan.
Types of balloon loans
Five-year balloon mortgages usually have a reset option at the end of the term. This allows the borrower to reset the interest rate based on current interest rate. Thus, he can recalculate the amortization schedule based on a new term.
With balloon loans that do not have reset options, the borrower has to pay the balloon payment or refinance the loan before the original term is due.
Pros and cons of balloon loans
Probably the best thing about balloon loans is that they come with flexible interest rates. You can enjoy one rate for five to seven years, instead of 30 years, and afterwards you can pay everything off or refinance, possibly at a lower interest rate.
The downside is that, if you can’t refinance or if the value of your home drops and you can’t sell it at the right price, you may default on the loan. And if you do manage to refinance the balloon loan, the new interest rate might be higher and will increase your monthly payments.