What Is a Balloon Loan
A balloon loan is a type of financing with a long term and competitive rate that many borrowers find attractive. Unlike conventional loans, it doesn't amortize and the principal amount is due at the end of the term.
The mortgage amount is the expected or original loan balance while the total payments are the payments made over the loan term provided that there are no early prepayments. The term usually ranges from 5 to 7 years, but this varies from issuer to issuer. Issuers that advertise prepayment options offer different frequencies, from one-time to yearly, monthly, or none. Prepayments vary in type and are applied to the loan principal.
A balloon payment is basically a payment made to cover the outstanding principal. In other words, the balance is due at maturity. The main benefit to a balloon payment is that borrowers who don't have a large sum of money for a down payment have an alternative option.
Balloon Loan Example
If the price of the property is $250,000, the term is 10 years, and the interest rate is 4.5 percent, then the balloon payment is $201,490 and the interest payment is $1,266. If the term is 5 years, however, the balloon payment is $229,161. It will increase to $ 238,603 if the term is 3 years. A longer term of 15 years gives a lump sum payment of $166,852. In this case, the borrower will pay a total of $393,594 and the total interest is $143,594. In general, if a borrower applies for a 5-year balloon mortgage to buy some property, equal monthly payments are distributed over a period of 5 years at a fixed rate. The remainder of the principal or the balloon payment is due in five years.
Balloon Loan Calculator
There are different calculators to help calculate the amortization schedule. Users plug in numbers for the start date, number of monthly payments, amortization period, annual interest rate, and loan amount. The calculator shows the total interest and payments made, and the balloon and monthly payments. There are other calculators online that ask for the periodic payment, due at period, final payment, and loan amount. Users also specify the payment method (advance or arrears) and the frequency – annually, semi annually, twice monthly, weekly, daily, etc. The calculator shows the total amount paid in interest. Some calculators are designed to show charts and the payment schedule. Users can choose from different currencies (US dollar, British pound, Euro, etc). With some calculators users are free to include the amortization schedule and specify a start date (month and year), optional monthly prepayment, number of years, and payment interval.
Balloon Loan vs Fixed Rate
Customers are offered a choice between fixed interest or a balloon loan, and one of the main differences is that borrowers qualify for a larger loan amount when applying for a balloon loan. On the other hand, the term may be shorter compared to traditional mortgages. Fixed-rate mortgages are risky for financial institutions because if interest rates increase substantially lenders are stuck with a low rate that remains the same over the whole term. Balloon mortgages also carry risk because borrowers may be unable to meet the lump sum payment at the end of the term. Some issuers offer two-step products whereby the mortgage reverts to an amortizing payment schedule at some point. When choosing between a fixed rate and a balloon loan, two factors play a role – the term offered and the interest rate. As a rule, it is easier to qualify for a balloon loan than for a FRM, and the monthly payments are more affordable.
Balloon Loan vs Adjustable Rate Mortgage
Both loans are similar in that they have an initial fixed-rate period. Then the interest rate is adjusted and fluctuates. One difference between ARMs and balloon loans is that the latter offer a lower interest rate. The reason is that financial institutions adjust their rates to the market rate when the initial period is over. Lenders that offer adjustable rate mortgages must comply with restrictions such as rate caps. This means that they usually offer higher interest rates during the initial period. Balloon loans, on the other hand, adjust to the prevailing market rate, regardless of how high it is. Customers who opt for an adjustable rate mortgage are protected against interest rate pikes. The rate caps apply even if the borrower’s credit rating changes as the limits are set out at the beginning of the term. There are no restrictions on refinancing with balloon mortgages.
Pros and Cons
This mortgage is a good option for borrowers who plan to sell the property before the end of the term. Employees who know that their company will relocate them in 3 years may choose a balloon loan. Thus they have more free cash to make investments. On the downside, borrowers who are unable to meet the outstanding balance or balloon payment at the end of the term may be forced to sell the property or refinance.
A balloon loan is not an effective way to build home equity but allows home buyers to leverage their money. Many borrowers are unable to meet the lump sum payment, however. Some borrowers refinance with a new lender while others stay with their existing lender. One option is to refinance with a new lender and try to negotiate better terms and a lower rate.
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