Balloon PaymentExplained & Defined

Written By:
Adiste Mae

What is a Balloon Payment?

A balloon payment is a larger lump-sum amount to be paid at the end of a balloon loan, similar to a bullet repayment. 

A Balloon Loan is a type of loan that usually has a shorter term compared to the traditional installment loans as it allows borrowers to reduce the fixed payment by making a larger one-time payment at the end of the term. 

Understanding Balloon Payments

Balloon payments are commonly at least twice the amount of fixed or regular loan payments.

These are mostly available for mortgages, auto loans, commercial loans, and business loans.

However, most balloon loans are commercials loans because an ordinary homeowner might face challenges when making a large balloon payment at the end of the loan term. 

In a mortgage balloon payment, the borrower pays a set interest rate for a given period.

When the loan resets or the low payment period ends, it’s common for the borrowers to refinance their mortgage or sell their property before the loan’s maturity.

When balloon loans have a reset process, it is not done automatically and there are several factors that affect it such as the timely payment of the loan and the consistency of the income earned by the borrower.

When a balloon loan does not reset, the balloon payment becomes automatically due.

Balloon Payments vs. Adjustable-Rate Mortgages

Adjustable-Rate Mortgage (ARM), sometimes called a variable-rate mortgage, is when a borrower receives an initial interest for a fixed period, then it resets periodically until the loan is repaid. 

One notable difference between the two is that the ARM adjusts the interest automatically or fluctuates based on the market benchmark.

ARM is a lot easier to manage as the borrower doesn’t have to refinance the mortgage.

Disadvantages of Balloon Payments

Balloon payments for an average borrower are riskier as there is no guarantee for a refinance which will result in them to default on their loans.

Given the housing market situation, it is less likely for them to sell their homes for as much as they expected and they will have no choice but to enter foreclosure.

Balloon Payment Qualifications

Lenders are required by the Truth in Lending Act implemented by Regulation Z to thoroughly check the borrower’s capacity to pay before they are granted a mortgage loan.

Regulation Z also specifies the criteria that lenders must meet before they can disregard balloon payments from their analysis.

The issue with some lenders is that they try to work around the Truth in Lending Act when they provide mortgages due to the limited ability of borrowers to make balloon payments.

What they do instead is that in their evaluations, they do not include the large payments, and the ATR of the borrower is based on their preceding payments.