Balloon Payment

A balloon payment is a larger than usual, one-time payment required at the end of the loan. The benefit of a balloon payment is it can lower the monthly payments on a loan, but it can also generate significant interest payments as well.

Balloon payments can be used to make car purchases. For example, if you decide to borrow $25,000 over five years you may expect to pay close to $400 each month. If, however, the lender agrees to a $5,000 balloon payment at the end of the lease term your monthly payment may be lowered to $345 or less.

Balloon payments may also be used to purchase a home. Although not allowed for all types of mortgage loans, if allowed, balloon payments can be used with both an adjustable rate mortgage (ARM) or a fixed rate mortgage.

Balloon payments were popular prior to the housing crisis, but after the crash lending standards tightened and the practice fell out of favor. Prior to the housing crash, however, it was common for lenders to issue adjustable rate mortgages. Under these mortgage arrangements, the borrower was initially given a low interest rate payment but the interest rate “ballooned” over the life of the loan.

Unfortunately, when their mortgage payments increased, many homeowners found that their property values had declined, and they were unable to sell or refinance their homes. When the payments came due homeowners were not able to make the payments, and many of them were forced to file bankruptcy or enter foreclosure.

Due to the risk of balloon payments, prior to using this strategy to purchase a car or home, you need to make sure you understand the costs of borrowing and what could happen if you cannot repay your loan.