Balloon Payment Clause: Everything You Need to Know
A balloon payment clause is a clause in a loan contract that requires the final payment of the contract to be much larger than the other payments.3 min read
What Are Balloon Payments?
In general, balloon payments are included with non-amortized loans. These payments occur when the remaining balance of the loan is payable and due. The loan may include an early due date, and on this date, the entirety of the remaining balance will be due. Balloon payment clauses can typically be found in "straight loans," which are also called "interest-only loans." In some cases, an adjustable-rate mortgage loan may also include a balloon clause.
Financing contracts can include a balloon clause in some circumstances, even if the loan isn't related to real estate. Balloon payments are most commonly used for home mortgages. The type of loan will dictate how the balloon payment will take place.
Advantages of Balloon Payments
For some homebuyers, a balloon mortgage can be a good option. The main benefit of these loans, which are found on the mortgage market, is that their initial payments are much lower than those for other types of loans.
Businesses can also make use of balloon loans. For instance, if your business is having cash flow problems, but you expect higher cash flow in the future, a balloon loan can help you stay afloat until your cash increases.
The length of a balloon mortgage is usually between five and seven years, which is relatively short. Payment of these loans, however, is based on a 30-year term. Qualifying for one of these loans is easier than it is for a 30-year fixed mortgage, and the interest rate will normally be lower than with a traditional loan.
Drawbacks of Mortgage Loans
If you're considering applying for a loan with a balloon payment, there are certain risks that you must keep in mind. When your loan term ends, you have to pay the remaining balance. Because balloon payments are so high, this means you would probably need to:
- Refinance the loan.
- Sell your home.
- Transition from a balloon to a normal mortgage, which means that current interest rates would apply.
Balloon mortgages first became popular in the 1970s. To help people purchase a home, it was common to combine their traditional loan with a mortgage that didn't require payments. This second mortgage was known as a "straight note." These second mortgages were often very beneficial, as long as they were for only 10 percent of the price of the home. Because these loans required no payments, they were a good tool for creating cash flow.
Investors appreciated these loans because they would often see a benefit if the taxes and insurance were low enough. The idea behind these second mortgages was that the property involved would increase in value over the three-year term of the mortgage. This made sense in the 1970s since both interest and appreciation rates were very high.
The risk behind balloon mortgages is that there is no guarantee that appreciation will occur. Further, it's entirely possible that the housing market will fall, causing the property to lose value.
About Balloon Payment Clauses
The interest and the principal are the two main components of loan payments. When you enter into a loan, the lender determines your monthly payments based on the total loan amount and your interest. This amount will be divided into monthly installments. Your early loan payments will mostly go towards your interest, and payments later in the loan term will go towards the principal, meaning the actual amount of the loan.
In some loan agreements, there is a balloon payment clause, which mandates an increased final payment. Typically, balloon payments are due between five and 10 years after the purchase of a home. Lenders often state that balloon payments are beneficial because monthly payments will be lower than with most loans, and the loan itself is easier to obtain.
For most buyers, a loan with a balloon payment is a poor choice. Only borrowers who already plan to refinance early in the loan's term, and who are expecting an increase in income, should consider one of these loans. Most borrowers will find it difficult, if not impossible, to pay a balloon payment. If they are unable to refinance, they may face foreclosure because of the inability to make this payment.
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