Balloon Loan

What is a Balloon Loan?

A balloon loan is a loan type that does not completely get paid off over its tenure. In fact, towards the end of the tenure, it requires to pay the principal balance of the loan.

Typically, this loan type attracts short-term borrowers as they can acquire the amount at lower interest rates. However, in comparison to other loan types, this one carries a higher risk.

How Does it Work?

The most common types of loans associated with a balloon payment are the mortgages. Typically, balloon mortgages have short terms that Range anywhere from 5 to 7 years. However, the monthly payments get calculated as if the loan has a tenure of 30 years.

Having said that, the payment structure for this type of loan is substantially different from a traditional one. The reason behind this is towards the end of the term; the borrower has only paid a certain amount of the principal balance. And, the rest of it is due to pay at once.

Example

Let’s assume that a person has taken a mortgage of Rs. 200,000 with a tenure of 7 years at 4.5% of interest. Now, the monthly payment for 7 years would be Rs. 1013. And, at the end of this term, the borrower will still owe Rs. 175,066 in the form of a balloon payment.

Pros of Balloon Loans

• Lower monthly payments in comparison to the traditional loans

• The ability to borrow more because of little principal has to be repaid
• Lesser tenure, which means paying the interest rate for a lesser number of years in comparison with the traditional loans

Cons of Balloon Loans

• If the principal balance is not repaid on time, the borrower can turn a defaulter
• Higher interest rate increases monthly expenses, which makes it difficult to stick to the commitment
• After the end of the term, the remaining balance, excluding the portion of the repaid principal balance, has to be paid off at a single shot, which could be extremely difficult for a majority of people; thus, the risks are higher with balloon loans, and the borrower can Default the payment quite easily