Balloon Loan - Explained
What is a Balloon Loan?
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Table of ContentsWhat is a Balloon Loan?How Does a Balloon Loan Work?
What is a Balloon Loan?
A balloon loan refers to a type of loan that does not have full amortization over its term. This type of loan requires that the remaining principal amount to be paid at the end of the term because it lacks full amortization. Balloon loans carry low interest in the short term, compared to long-term. Therefore, it is more attractive to the short-term borrowers compared to the long-term borrowers. However, the balloon loan also contains the refinancing risks since the loan can reset at a higher interest rate at any time
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How Does a Balloon Loan Work?
Some balloon loans have reset period that occurs after the end of a particular term. For example, a five-year balloon mortgage resets its interest rate after the end of every five-year term. The reset is based on the current interest rates, and the reevaluation of the amortization schedule is based on new terms. When the balloon payment does not carry the reset option, the lender is compelled to pay the balloon payment to refinance the loan before the original terms lapse. The balloon mortgages are the loans associated with balloon payments. Mostly, the balloon mortgage loans tend to have short term period ranging between five to seven years. However, the monthly payment of the short-term mortgages is not set to cover repayment of the whole principal amount. Instead, the calculation of the monthly payments is made to make the loan appear as the traditional 30-year mortgage. The example below demonstrates the calculation of mortgage loan at a specified interest rate. The calculation for the repayment and the payment structure of the balloon loan differs from the traditional loan. The difference occurs because, at the end of the term stipulated, the borrower only pay a proportion of the principal amount and the rest amount remaining to be paid at once. After the end of the term, the borrower has the option to sell to home to pay the remaining balance or borrow out a new loan to repay the remaining amount and refinance the mortgage effectively. Besides, the borrower can also make payment is cash. For example, when an individual borrows a balloon mortgage loan of $200,000 with a seven-year term at an interest rate of 4.5%. He would pay a monthly interest of $1,013 for seven years. Therefore, at the end of the term, the borrower will be owing to a balloon payment of $175,066. The balloon loan has various advantages to the borrowers based on their interest rate and short term. One of the major advantages of this kind of loan is that it has flexible interest rate that allows the borrower to pay at their convenience. Instead of committing to a fixed interest rate for a long period, for example, 30-year term, the borrower enjoys one rate for a short term and then get their loan refinanced at a slightly lower rate of interest. Despite the advantages, the loan also has some of the disadvantages. One of the significant drawbacks of balloon mortgage the borrower cannot get the loan from other institutions or the current lender to finance their balloon payment and thus may default on the loan. Similarly, when the borrowed resort to pay the loan by selling their property at a lower price, they are also likely to default the loan. In some cases, even if the borrower is capable of refinancing their loans successfully, they may do it at a higher interest rate.