A balloon loan is a loan with a lower regular payment amount and a lump sum due at the end of the loan period. The balloon loan payment is a combination of both principal and interest. The payment can either be amortized over a specific period of time, such as 5, 10, or 15 years, with a large payment due at the end of the loan term; or payments can be made based on the interest-only component with a large payment due at the end of the loan term that includes the loan’s principal balance.

Loan costs and risks

With a balloon loan, the borrower bears the risk of having to pay a large lump sum at the end of the loan period. This risk can be compounded if the borrower’s income is volatile or the loan is refinanced at a point when interest rates have increased. In most cases, the balloon loan will require higher payments than a standard amortized loan. Additionally, if the balloon loan is refinanced, the borrower will incur additional costs such as loan origination fees.

Uses of Balloon Loans

Balloon loans are often used by businesses and individuals in order to keep initial loan payments low. They are especially useful for borrowers with limited funds but who expect to receive large cash inflows later on from interest payments or sale of assets.

Balloon loans can also be used to postpone a loan payment for a period of time in case of a financial emergency. For instance, a balloon loan can be used to consolidate debts in a shorter loan period with a balloon payment of the consolidated debt at the end of the payoff period.

In some cases, a balloon loan can be useful for financing a large purchase since a balloon loan’s initial payments will typically be lower than those of a standard amortizing loan. Additionally, they are often used in situations in which the borrower needs a loan to bridge cash flow gaps until a period of patient capital can be established or until a sale or refinance of the property can occur.

Overall, balloon loans can help borrowers with limited funds and minimal risk to finance a large-scale purchase or consolidate debts. However, the required higher payments and risks should not be ignored when evaluating different financing options. For the right borrower in the right situation, a balloon loan can be an efficient way to finance a purchase.