A balloon payment refers to a large, lump sum payment that comes due in a balloon loan. A balloon loan is more likely to be a commercial loan as opposed to a residential loan. Balloon is the terminology used to describe a final note payment which is much larger than the previous monthly payments. A balloon loan is made for a relatively short term and only a portion of the original principal balance is repaid during the loan term. When the balloon payment comes due the entire remaining principal balance is due. A balloon loan is typically described as A due in B where A is the term over which the loan is amortized and B is the due date of the balloon payment. As an example, a 20 due in 5 would a loan whose payment is amortized based on a 20 year term but comes due in 5 years.
A balloon loan is often set up with a lower initial interest rate or possibly interest only to make the payments easier to make. A balloon loan can make sense if you plan to sell the property before the balloon payment comes due. On the other hand the most common way of dealing with the large payment is to refinance the property. Careful planning must be exercised to assure that a refinance will be possible when required.
Some of the risks associated with refinancing could be that the borrower’s financial condition could have deteriorated or that the required down payment for the new loan might not be available. Also, if some of the covenants of the loan agreement have not been met by the borrower the bank may not be willing to consider refinancing the debt with a permanent loan. Falling property values could also make a refinance impossible. Clearly the risks are both with the borrower and his bank. If the borrower cannot deal with the balloon payment the bank may be faced with and overdue payment.
Some balloon loans are set up with a “two step” mortgage feature, sometimes called a “reset’’, that guarantees the borrower that his loan will be refinanced typically at the current market interest rate and will feature a normal amortization. This feature will typically require that the borrower maintain his payment schedule as agreed and that no addition liens are placed on the property.
An adjustable rate mortgage (ARM) can also be a good option. With an ARM the loan interest rate for the initial period of one to five years will often be lower than a fixed rate loan. The loan interest rate will adjust automatically at the end of the initial period and will usually adjust periodically thereafter. The lower initial rate can be attractive to the borrower who wants a lower payment up front but is willing to accept future payment adjustments.