A balloon loan is a type of loan that does not fully amortize in its term. When a loan does not fully amortize. It takes the pattern of a balloon payment at the end of the term to repay the. Remaining principal balance of the loan. However, balloon loan is common among short-term borrowers. Because they are offered with lower interest rates compared to longer terms. Nonetheless, the borrowers must be aware of the refinancing risks because. It is possible that the loan may arrive at a higher interest rate.
How a Balloon Loan Works
However, mortgages are especially associated with balloon payments. In balloon mortgages, it is a short-term loan that commonly lasts. Least five to seven years. The monthly payment for the short term in. This context will be estimated as though it is a traditional 30-year mortgage.
You should also understand that the payment structure for a balloon. A loan differs from a traditional loan. This is because, at the end of five to a seven-year term. The borrower is expected to pay off. Only a fraction of the principal balance and the remaining due once. The borrower may be forced to sell the home in. Order to cover the balloon payment or take out a new loan to cover the payment. In this case, the borrower has effectively refinanced the mortgage.
Also note that some balloon loans that last five years e.g. balloon mortgage, eventually have a reset option at the end of the five-year term over the interest rates and may go in accordance with the current interest rate. But if the balloon loan does not permit or agree to a reset option at the end of the term, it warrants that the borrower will pay the balloon payment either by refinancing the loan before the end of the original term.
Advantages of Balloon Loans
- Firstly, a balloons loans has much lower monthly payments compared to a traditional amortized loan. Also, the principal repaid is low and permits an individual to borrow more compared to what a traditional amortized loan can offer an individual.
- Secondly, when the interest is high, the pressure is lesser because the borrower is just expected to repay the interest.
- If probably the interest rates are high, the borrower gets to refinance at a lower interest rate eventually after five to seven years.
Disadvantages of Balloon loans
- Defaulting on the loans may occur especially if the borrower cannot convince their current lender or another entity to finance the balloons payment or may not raise the funds to pay off the principal balance.
- The property value may fall and cause default because the property when sold cannot measure up to pay off the balloon payment.
- It may demand refinancing the balloon loans to be able to pay off the principal. You may dangle into a very high-interest rate loan on the course to refinance the Balloon loan to pay off the debt.