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What is a balloon payment?
Find out how you can use a balloon payment to get lower monthly payments for the duration of your loan.
Balloon payments can lower the monthly cost of your loan, but they also come with significant financial risks. Find out more about what a balloon payment is, when it might be helpful to use and what you should keep in mind before you sign on the dotted line.
What is a balloon payment?
A balloon payment is a lump sum payment that needs to be paid at the end of a loan. This type of payment can help you qualify for lower monthly payments so long as you agree to pay whatever balance is remaining when your loan expires. The term “balloon” indicates that the final payment is significantly large.
Loans that offer balloon payments usually have shorter terms than traditional instalment loans. They also come with much higher risk for the lender since there’s a bigger chance of the borrower defaulting on a large payment. For this reason, they’re typically reserved for borrowers with excellent credit and a decent income.
Balloon loans are often taken out as business loans by new companies that only begin to generate profits after a couple of years. They can also be used for mortgages or auto loans, with borrowers often planning to sell off the asset before the final balloon payment is due.
Example of a balloon payment
Let’s say you want to take out a loan of $100,000 to cover the start-up expenses of a new business. You set the term of the loan at 5 years and agree on a 5% interest rate. After some quick math, you figure out that the total amount of your loan will be around $122,833.
Then you take a look at your budget. You realize that you can’t afford to make the $1,700 per month payments on such a large loan. But you can afford to pay around $1,000 a month, at least until your sales pick up and you start processing invoices. Lucky for you – this is where balloon payments come in handy.
Your lender may be able to offer you a monthly payment of around $1,000 provided that you make a lump sum payment when you’re in a better financial position. The lump sum payment in this case would be around $50,000 at the end of five years.
Advantages and disadvantages of balloon payment
- Lower initial payments. You’ll only have to pay a portion of the loan upfront so your payments in the beginning can sometimes be cut in half compared to a normal loan.
- Less interest. You’ll pay less interest over time because the term of your loan will typically be shorter (although you will often be charged higher interest rates).
- Affordable financing. You can use a balloon payment to defer or minimize payments until you have a larger cash flow.
- Large final payment. Final payments on balloon loans can cost you thousands of dollars, which means you’ll likely need to tap into your savings to wipe out your debt.
- Higher risk of defaulting. If you don’t have enough money to make your final payment, you risk your loan going to collections (which can negatively affect your credit score).
- Increased chance of repossession. Your lender may be able to take back the asset you purchased with your loan to cover the cost of the balloon payment if you can’t afford it.
- Requires good credit. You’ll need a high credit score to qualify given the added risk for lenders, so borrowers with bad credit might not be able to take out this kind of loan.
Who should consider financing via balloon payment?
A balloon loan could be a good financing option if you fall into one of the following categories.
- New business owner. You’re just starting a business and expect your cash flow to pick up in a couple of months.
- Expecting a lump sum of cash. You’re about to receive a large amount of cash from a bonus, inheritance or lawsuit and you need some money to tide you over until it comes in.
- About to pay off a large debt. You’re at the tail-end of paying off another large debt which will free up capital in the near future.
- Looking to refinance or sell off assets. You’re prepared to refinance your loan or sell off the asset to cover your costs before the balloon payment comes due.
What should I keep in mind before considering this?
- The amount you can afford to pay. You’ll need to consider how much money you can reasonably afford to put aside to cover your final payment.
- How much your final payment will be. Make sure you’re clear on how much you’ll have to pay so that you don’t end up blindsided when the final amount comes due.
- The level of risk you take on. It’s important to understand what kind of risk you’re taking on and know what will happen if you default.
- Whether or not you stand to lose money. You should be prepared to lose money in the end if your asset depreciates and you have to sell it to make your final payment.
What are my alternative options?
Balloon payments are a risky option and should be used with caution. Alternative options that could be a better fit for your particular financial situation include:
- Secured loan. You may want to look at securing your loan against an asset to get lower interest rates and a more flexible repayment schedule.
- Guarantor loan. You could ask a friend or family member with good credit to cosign your loan if you want better rates and terms.
- Line of credit. Try taking out a line of credit if you only want to pay interest on what you borrow (while still having money on hand in case of an emergency).
- Consolidate debts. It could help to consolidate your debts to see if your monthly payments would be lower, which would free up some extra income.
- Renegotiate terms of purchase. If you’re making a large purchase, you may be able to get deferred payments or a custom payment plan.
- Borrow from loved ones. You could ask friends or family to float you some cash to help cover the costs of monthly payments on a normal loan.
- Ask for less money. Try to borrow less to get your monthly payments down to a manageable amount on a loan without a balloon payment at the end.
Balloon payments can lower the monthly cost of your loan but come with significant financial risk. Learn more about when they might be a good idea and compare lenders to find the best deal.
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