Understanding balloon payment and its implications

[ecis2016.org] Balloon payment is like a lump-sum payment of a loan or mortgage, made towards the end of loan period and is higher than the monthly instalments

Loan borrowers are required to repay the principal, along with interest on the borrowed amount. The longer the tenure, the larger the interest component. At times, the interest payable is higher than the principal, which makes the loan very expensive. To avoid paying a high interest, home loan borrowers opt for balloon payment, under which a large amount is paid towards the end of the loan tenure while only the interest is paid in monthly instalments.

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What is balloon payment?

Balloon payment is like a lump-sum payment of a loan or mortgage, made towards the end of the loan period and is higher than the monthly installments. If a balloon payment is attached to the loan, the borrower can easily cut down on the interest component, as the entire loan is not amortised. Such kinds of payments are attached with relatively short-term loans.

The term ‘balloon’ indicates the final payment which should be significantly large, usually twice the amount of the loan’s previous payments. Such repayments are more common in commercial lending than in retail loans, because the average home owner or consumer cannot make a very large balloon payment at the end of the loan.

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Benefits of balloon payment

If a balloon payment is attached with the loan, the initial EMIs on such borrowings is very low. Such loans are ideal for companies or individuals who have seasonal jobs or are facing a cash crunch in the short term but are expecting improvement in the future.

Also, if a loan has a balloon payment clause, then, the borrower will be able to save a lot of interest amount on the monthly instalments. In a regular loan, if there is no balloon payment attached to a loan, the entire loan amount will be amortised. However, in a loan which has a balloon payment clause, the lump-sum principal will be paid towards the end of the term and only that principal balance is amortised over that period.

Disadvantages of balloon payments

Such payments can be a huge challenge in a falling housing market. If the property prices fall, the value of the home owner’s equity in the property will also drop and the borrower will not be able to sell the home for the right price. This could result in loan defaults or foreclosure, if the borrower is not able to make the balloon payment.

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Pros and cons of balloon payment

What is an example of a balloon payment?

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To understand a balloon payment, consider this:

Suppose you take a loan of Rs 10 lakhs for 10 years. You have a balloon payment scheduled in the third, fifth and seventh year. Now, your instalments will be low and in the third, fifth and seventh year, you will be required to pay a large principal amount as balloon payments.

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What happens if you cannot pay your balloon payment?

If the borrower is unable to make the balloon payment, he may have to look for a refinancing option or sell the asset, to recover the money. The lender may also foreclose the asset, to recover the funds.

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