There are some payments you might be required to make when you get a balloon loan from a lender. One of such is a balloon payment.
For instance, if you obtain a balloon loan like a mortgage, a commercial loan or any other amortized loan, you’re required to make a large payment at the end of the loan.
That large payment is the balloon payment of whatever loan you have obtained.
In many cases, a balloon loan is not a long-term loan. As such, only a part of its principal balance is amortized during the time of the loan. Whatever balance is left will be due as the last payment when the term of the loan ends.
Considering the meaning of the word “balloon” it’s obvious that the final payment is notably large. In many cases, balloon payments are often a double of the amount of the loan’s payment in the past.
Many borrowers and homeowners often plan ahead with two options in mind. The first is for them to either refinance their mortgage as the payment of the balloon draws nearer.
The second option is for them to sell their homes prior to the maturity date of their loans.
There are less balloon loans in consumer lending compared to commercial lending. This is because many homeowners are not interested in making a large balloon payment when their mortgage ends.
Types of Balloon Payments
Typically, balloon payments are grouped into two-step mortgages. The borrower is requested to pay a determined interest rate for a precise number of years.
Afterwards, the loan resets and the balloon payment revolves into a new or ongoing amortized mortgage at the trending market rates when the term ends.
The reset method is not usual with all two-step mortgages.
Rather, it is based on several factors, like if the borrower has made regular payments on time and if his income has been consistent. But if the loan doesn’t reset, the balloon payment will be due.
Important things to note:
- Typically, balloon payments are at least a double of the amount the borrower paid on the loan in the past.
- Balloon loans are often fairly short-term and only a part of the loan’s principal balance is amortized during the loan’s lifetime.
- A balloon payment can turn out to be a huge problem in a poor housing market. This is mostly true in a situation when owners find it difficult to sell their properties for as high as they assume before the balloon payment is due.
Are Balloon Payments And Adjustable Rate Mortgages The Same?
It’s easy to assume that a balloon loan is the same as an Adjustable Rate Mortgage (ARM) – but they are not.
If you choose an ARM loan, you will get an introductory rate for a determined period of time and this is usually within one to five years.
During that period, the interest rate will reset and it might reset over and over again during certain periods until you pay back the entire loan.
So typically, an ARM resets automatically – in contrast to some balloon loans. As a borrower, you’re not required to obtain a new loan or even refinance a balloon payment.
Considering that, adjustable rate mortgage is a lot easier to deal with.
Merits and Demerits of Balloon Payments
As I mentioned earlier, balloon payments can be a huge challenge in a poor housing market.
As the costs of homes fall, the possibility of homeowners having positive equity in their property also nose dive and then the possibility of selling their property for as high as they assume also drops dramatically.
As such, borrowers are usually left with no other option than to default on their loans and end up in a foreclosure irrespective of their household incomes, when thy have to deal with a balloon payment that is too large to pay.
Eligibility For Balloon Payments
According to regulation Z of the Truth in Lending Act, banks are mandated to fully investigate a borrower’s creditworthiness otherwise known as ability to repay (ATR) before offering them any mortgage.
However, some lenders have worked a way around this rule with balloon mortgages. This is because many consumers don’t have the required financial capability to make major balloon payments.
As such, many lenders omit this large payments in their assessments and only evaluate a borrower’s ATR on only the previous payments.
Regulation Z has precise prerequisites that lenders are required to meet before they can turn a blind eye on a balloon payment from their evaluation.