Balloon Interest – Definition

Cite this article as:"Balloon Interest – Definition," in The Business Professor, updated January 24, 2020, last accessed October 22, 2020, https://thebusinessprofessor.com/lesson/balloon-interest-definition/.

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Balloon Interest Definition

Balloon interest refers to paying a higher coupon rate on financial instruments held over the long term within a serial bond issue.  A serial bond issue has its bonds maturing at different dates but a term issue bonds mature at a specific date with the rest.

A Little More on What is Balloon Interest

Ballon interest comes to play in a serial bond interval when the bonds mature at different intervals but an important part of the bonds mature exactly the same date.

A serial bond is structured to have different maturity dates, but a part of the bond can mature together. The bonds mature gradually over a period of time. The bonds are specifically used to fund projects which will continually yield income for bond repayment. Bonds sold have documented details with included maturity dates.

It is possible to earn high interest and also extend the bonds when a serial bond has been issued, due to the reason that the investor is making more profit and wishes to hold the instrument longer. Investors refer to this coupon rate as balloon interest.

Serial bonds are acquired so as to fund  projects which is projected to have a stable means of income at the point of paying or when balloon interest is due.

A part of the bonds or the bulk of the bonds may mature at the same time while the rest mature at different intervals, but when the majority of the bonds mature at the same time, it is referred to as a serial bond with a balloon. The balloon is used due to the fact that a large percentage of the term bonds matured in the final year of the issue’s term.

Calculating Bond Interest Rates

When a rate is able to reduce all of the future cash receipts to the amount of cash paid to purchase the bond, then that’s the actual, real, or effective interest rate. This intereat rate is also referred to as the yield to maturity or market interest rate.

The actual or real interest rate of a bond is calculated by multiplying the bond interest rate against the actual amount of the bond against one-half of a year plus the maturity amount of the bond. This could be done using a financial calculator or value software.

The maturity amount to be paid is done once. When the interest rate of the bond rises above the current market interest rate, it will result in market value which is higher than the maturity or actual amount of the bond. The bond will sell at a premium price but on the other hand, when the bond’s interest rate is lower than the present market interest rate, the bond’s market value will be less compared to the maturity or actual amount of the bond. Then the bond will sell at a discount.

Zero-coupon bonds are paid at maturity. At this time, their prices are likely to change suddenly unlike coupon bond pricing. Zero-coupon bonds are traded at a discount, and they allow for-profit at maturity when the bond is bought for its actual value.

Reference for “Balloon Interest”

https://www.investopedia.com › Investing › Bonds / Fixed Income

https://investinganswers.com/financial-dictionary/bonds/balloon-interest-5741

https://www.thebalance.com › Personal Finance › Banking and Loans › Getting a Loan

https://www.gulfbend.org/poc/view_doc.php?type=doc&id=10688&cn=217

https://www.thecalculatorsite.com/articles/finance/balloon-payments.php

Academic research on “Balloon Interest”

Consumers in Mortgage Markets, Perry, V. G. (2014). Consumers in Mortgage Markets. In Introduction to Mortgages & Mortgage Backed Securities (pp. 143-160). Academic Press. This chapter begins by examining mortgage decisions from a rational, economic perspective. Models of fixed-rate versus adjustable-rate, loan term, and prepayment and default decisions are introduced. This section is followed by an overview of the role of psychological factors on mortgage decision processes, such as financial knowledge and information search behavior. Several decision-making principles are presented that may affect borrowers’ attention to and evaluation of mortgage products, including cognitive miserliness, decision heuristics such as hyperbolic discounting, framing and mental accounting, and biases in decision-making, such as status quo and loss aversion. In addition, several important contextual influences on mortgage decisions are discussed, including lender marketing activities and the regulatory environment. Finally, marketplace conditions that warrant consumer protection in mortgage markets are explained, along with a description of recent regulatory efforts of the US Consumer Financial Protection Bureau. An important conclusion is that no extant model fully incorporates all the economic, behavioral, and situational variables that are relevant to actual mortgage borrowing decisions.

Debt or Equity-New Pathways-Another Dead End of the Yellow Brick Road, Salem, I. (1990). Debt or Equity-New Pathways-Another Dead End of the Yellow Brick Road. Tax Executive42, 93.

A Comparative View of Underwriting, Deregulating, and Overturning in Banking, Barr, J., & Lasher, N. A Comparative View of Underwriting, Deregulating, and Overturning in Banking. During the 1980s, Congress passed a number of laws deregulating the US banking system and home loan process. Within a decade, this caused the demise of many savings and loans and has had major effects on banking into the twenty-first century. Several pieces of legislation have contributed to deregulation of the industry including Graham Leach Bliley and the Deregulation Monetary Control Act. In addition, more complex variable rate mortgages became permissible through the passage of AMPTA, which has added greatly to the number of defaults. Complexity in home loans followed under the so-called Truth in Lending Act and misled homeowners through nondisclosure of mortgage information. Although these laws were intended to save the banking industry, they had quite the opposite effect and have severely impacted the economy today. Through statistical analysis of the nation‘s mortgage debt, this paper shows that the current economic crisis is twice as bad as the Savings and Loan crisis. Analysis also shows the effect of lax lending and loan-originating policies in both periods.

Extreme Hoards: Race, Reality Television & Real Estate Value During the 2008 Financial Crisis, Chihara, M. (2017). Extreme Hoards: Race, Reality Television & Real Estate Value During the 2008 Financial Crisis. Postmodern Culture27(3). Two hit reality television shows, just before 2008 and in the foreclosure crisis just after, disciplined particular economic subjects and naturalized historically specific immanent power structures. Extreme Makeover: Home Edition re-imagined the leveraged construction of massive houses in the exurbs. Its sentimentality and its reliance on ethnic minorities dove-tailed with the rhetoric of social justice that politicians used to push for deregulation of mortgage financing, then later facilitated the popular right-wing narrative blaming minorities. After the crash, Hoarders visually mimicked the stages of foreclosure. While Extreme Home Makeover sought to contain the bodies of the poor as static reserves of value in their own neighborhoods, Hoarders re-identified real estate value with normative mental health and commensurable white feminine domesticity.

The financial crisis of 2007‐2009: Causes and remedies, Acharya, V., Philippon, T., Richardson, M., & Roubini, N. (2009). The financial crisis of 20072009: Causes and remedies. Financial markets, institutions & instruments18(2), 89-137.

Macro risk factors of credit default swap indices in a regime-switching framework, Chan, K. F., & Marsden, A. (2014). Macro risk factors of credit default swap indices in a regime-switching framework. Journal of International Financial Markets, Institutions and Money29, 285-308. Using the Markov regime-switching model, this paper examines factor loadings on macroeconomic, market sentiment and other variables that may explain North American investment-grade and high-yield credit default swap indices (CDX) over the period 2003–2011. In both crisis and tranquil market states, spreads are positively related to the market-wide default premium and VIX, and negatively related to changes in Treasury bond yields, the underlying stock index returns and the Fama–French’s High-Minus-Low factor. The magnitude of the factor loadings is higher during crisis periods. The results suggest the need to consider regime dependent hedge ratios to manage credit risk exposure.

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