Balloon loans are loan arrangements that call for tendering a substantial payment at some point during the life of the contract. Often used as a means of financing the purchase of real estate, the balloon loan typically provides several years of making monthly installment payments, followed by one very large payment to settle the outstanding balance. These types of loans can be very helpful in some situations, but do present some potential drawbacks in certain situations.
One of the main advantages of a balloon loan is that the total amount of interest paid is relatively low in comparison with other forms of home financing. For example, the loan may be configured for seven years of monthly installment payments and one balloon payment at the end of those seven years. Assuming the balloon payment is met, the homeowner will pay considerably less interest than financing that same balance for a standard 30-year loan.
A balloon loan arrangement also provides the benefit of being relatively easy to refinance. Since most loans of this type will involve seven to ten years of monthly installment payments on the front end, there is a good chance that the homeowner will build equity in the property during that time. As a result, many lenders are more than happy to work with homeowners to settle the balloon payment in full and roll the amount into a 15 or 30 year mortgage with a fixed or floating interest rate. As long as the homeowner’s credit is sound enough to justify the loan, this arrangement can be used to buy time until interest rates are lower, then move forward with the refinancing effort.
There is also the fact that the balloon loan is normally flexible enough to allow the balloon payment to be made earlier in the process if the borrower chooses to do so. This means that if the financial circumstances of the homeowner improve substantially, the loan balance can be retired early and save even more on the total interest paid. In some arrangements, lenders may accept the balloon payment as early as a couple of years into the arrangement, and then allow the debtor to resume making the monthly installment payments to finish out the balance due.
While there are several benefits to a balloon loan, there are potential drawbacks to consider. Qualifying for this type of loan does require additional scrutiny on the part of the lender. The goal is to make sure there is a reasonable amount of evidence that the homeowner will be in a position to retire that balloon payment by the appointed date. In addition, some mortgage arrangements of this type include provisions for severe penalties in the event that the balloon payment cannot be tendered when the time comes. Those penalties may be sufficient to offset any benefits gained from using this particular approach to home financing, making it very important for potential homeowners to weigh the pros and cons of the balloon loan arrangement before settling on this option.