A balloon payment is the final amount due following a repayment structure that has a series of smaller monthly payments, with a larger lump sum due at the end of the loan term. Monthly payments can be interest-only or include principal, and the remaining principal amount is to be repaid in full with the last scheduled payment. Typically associated with balloon loans, a balloon payment provides a borrower with flexibility in their loan repayment structure by making lower monthly payment installments.
That said, the risk of balloon payments tends to be higher than traditional repayment schedules. If the borrower were to default on the loan, the lender would not have received the principal loan amount and would be at a loss. To mitigate this risk, balloon payments commonly have higher interest rates and applicable fees.
Key Takeaways:
- Balloon payments are commonly associated with business loans, equipment financing, and mortgages.
- Interest rates and fees can be higher with a balloon payment structure since they pose higher risk than traditional payment structures.
- Monthly payments are typically lower than traditional principal and interest payments and may allow a borrower to better manage their finances.
How a Balloon Payment Works
If a loan is structured with a balloon payment, equal payment installments are made monthly—with the exception of the last payment in which the remaining principal is due. Meaning, the lump sum balloon payment is made last, once the loan has reached the end of its term.
It differs from traditional principal and interest payments that would pay down the loan in equal installments over time—and the loan would be paid in full with the same monthly payment amount throughout the entirety of the loan term.
Example of a Balloon Payment
For a simple example of how this type of repayment structure might look, let’s say that a borrower is looking to get a $500,000 mortgage for an investment property. The mortgage is structured with a 10-year term, 30-year amortization, and a 5% interest rate.
With the balloon payment structure, this requires 119 monthly payments of $2,684.11 and a final lump sum balloon payment amount due of $406,710.60. Overall, the total interest paid over the course of the loan is $228,803.80—which brings the total financing amount to $635,514.40.
Types of Loans With Balloon Payments
There are numerous loan types that can have a balloon payment structure. They are also referred to as “balloon loans,” which are typically offered to well-qualified borrowers with strong financial and credit history.
Below are some of the most common loan types that may be eligible for a balloon payment:
- Commercial mortgage: This is the most common type of balloon loan. It’s usually used for short-term mortgages of 10 years or less. For borrowers looking into how to lease commercial real estate, this may be a solid repayment option.
- Equipment financing: For businesses needing equipment financing, a balloon payment may be applicable to certain financing opportunities. Depending on the kind of equipment and lender, you can finance the asset with low monthly payments and payoff and acquire the equipment at the end of the loan term.
- Business loan: If your business needs a working capital, most loans can be structured to support a balloon payment. This flexibility can allow the borrower to better manage their cash flow and prepare accordingly for the lump sum payment due at the end of the loan term. See our roundup of the best working capital loans for recommendations.
Pros & Cons of Balloon Payments
Pros | Cons |
---|---|
Low monthly payment requirements for the majority of the loan term | Interest rates associated with balloon loans tend to be higher |
Borrower can better manage cash flow of their business | Refinancing may be difficult depending on the loan type |
Fewer documentation is typically required of loans with balloon payments | Qualifying criteria may be more difficult and require strong credit and financial history |
Who a Balloon Payment Is Right For
Balloon payments apply to a variety of loan types and therefore can be used by a wide variety of borrowers depending on their financing needs. However, it may be better suited for borrowers who:
- Have strong credit and financial history: Most lenders will only issue financing with a balloon payment to creditworthy borrowers with a good track record of managing their finances. This is due to the fact that loans with balloon payments carry more risk in comparison to traditional loans with principal and interest payments.
- Are looking to free up cash flow: Borrowers wanting to have a low monthly payment obligation can utilize a balloon payment structure to free up cash flow for other aspects of their business. This is useful if you need financing right away but want to continue to save money before you have to pay off the majority of the loan.
- Are looking to make an investment: If you are financing an investment property, whether it be to acquire or rehabilitate the asset, you can use a balloon payment structure to cover the expenses and pay off the loan with proceeds from the investment.
Where to Get a Loan With a Balloon Payment
Balloon payments are a common financing option offered by many types of lenders. Depending on your financing needs, you can likely get a loan structured with a balloon payment from the following sources:
- Traditional banks
- Online lenders
- Private lenders
- Credit unions
That said, each lender may have varying qualification criteria applicable to the loan type and repayment terms. Common criteria includes credit score, annual revenue, and time in business. The stronger your credentials, the better your odds of approval.
Notably, loans associated with balloon payments tend to have fewer documentation requirements, depending on the loan type and lender. However, you should be prepared to furnish a variety of documents inclusive of:
- Business financials
- Personal financial statements
- Tax returns
Alternatives to Repaying a Balloon Loan
In some cases, a borrower may want to find other financing options before their last balloon payment is due. This may be because the borrower can’t afford it or simply wants to explore paying off the loan in a way other than a lump sum payment. These options include:
- Refinancing the loan: You can try to refinance your existing balloon loan if you are unable to meet the current repayment conditions. By refinancing and moving to a more traditional repayment structure, you won’t have a looming large lump sum payment due later on down the road and can simply pay off the loan in equal installments.
- Selling the financed asset: This method is commonly used with fix-and-flip loans, in which the borrower can use proceeds from the sale of the asset to pay off the loan. This is also applicable to a variety of loan types wherein you can sell off the financed asset and use the funds to make the final balloon payment instead of paying out-of-pocket.
- Making early principal payments: You can make incremental principal payments alongside your regularly scheduled monthly payment to either reduce the lump sum payment due at the end of the loan term or aim to pay off the loan early. Just ensure there are no prepayment penalties associated with the terms of your loan agreement.
- Requesting an extension: If you are nearing the end of the loan term and aren’t in a position to pay off the loan in full, you may be able to request a loan extension from your lender to give yourself more time to prepare.
Frequently Asked Questions (FAQs)
Balloon payments are considered to be higher risk due to the lesser payment involved during the majority of the repayment schedule. If a borrower is unable to make the final lump sum payment, then the lender may be at a loss and the borrower will be in default. Typically, this risk to the lender is offset with higher rates and fees associated with the loan.
The main disadvantages of balloon payments are that they are commonly more difficult to qualify for and that they may have higher interest rates. This is due to the fact that they typically pose more risk to the lender in comparison to other repayment structures. As such, you’ll have to demonstrate strong creditworthiness as a borrower and ensure you meet the minimum qualifications of the lender before applying for a loan.
A balloon payment structure can be useful in many instances. That said, it won’t be the best repayment option for everybody. It’s best suited for well-qualified borrowers looking to free up their cash flow or to make an investment that they plan to pay off quickly.
Bottom Line
In getting a loan with a balloon payment, there are benefits and drawbacks to consider before signing the agreement. A balloon payment allows you to make smaller payments throughout the term of the loan, with the lump sum payment due at the end of the term. It can be useful in managing cash flow and financing investments or for borrowers looking for a flexible repayment schedule. That said, it can be a riskier form of financing, and you should weigh your options carefully before committing to a decision.