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Balloon Loan Definition
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
A Little More on What is a Balloon Loan
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.
References for Balloon Loan
Academic Research on Balloon Loan
- Seven aspects of loan size, Schreiner, M. (2001). Journal of Microfinance/ESR Review, 3(2), 3. This paper explores seven aspects of loan size that do not only affect the outreach depth but also profitability. The seven aspects that the author considers evaluating the loan size include; the amount disbursed, the maturity term, average balance, amount per installment, number of installments, installment period, and “dollar-years of borrowed resources.” This paper further provides an in-depth definition and explain the importance of each aspect. The article also provides the measurement for each aspect based on the data obtained from three Latin American microfinance institutions.
- Predatory lending practices and subprime foreclosures: Distinguishing impacts by loan category, Rose, M. J. (2008). Journal of Economics and Business, 60(1-2), 13-32. The rise in subprime foreclosures over the recent period has led to the need for restriction of predatory loans. As such, this paper discusses various mechanisms that can be used to restrict subprime foreclosures in the lending. The study was based on the data obtained from the purchase of mortgages and subprime refinance that occurred in the Chicago metropolitan area. During the study, the author discovered that the balloon payments have significant impacts on the borrower that greatly reduce their profitability.
- Effects of the financial crisis and great recession on American households, Hurd, M. D., & Rohwedder, S. (2010). (No. w16407). National Bureau of Economic Research. This paper presents the impacts of the financial crisis and great recession. The data that was obtained from the American households using high-frequency data collections steered at tracking the great impacts recession and financial crisis. From the study, it was discovered that great recession widely spread November 2008 and April 2010. The author discovered that about 39 per cent of the households either had negative equity in their house or were unemployed and had house payment arrears. This was accompanied by a reduction in spending among the households and the rate of unemployment significantly increased.
- The loan structure and housing tenure decisions in an equilibrium model of mortgage choice, Chambers, M. S., Garriga, C., & Schlagenhauf, D. (2009). Review of Economic Dynamics, 12(3), 444-468. This paper focuses on determining and understanding of the structure of loan especially, balloon mortgage loan, affects the borrower`s choice of the mortgage contract and the aggregate economy. The author developed a quantitative equilibrium theory of mortgage selection that gives the household the opportunity to choose from the long-term menu provided. The study discovered that loan structure significantly affects the household decision to balloon mortgage. The study model also provided that the household`s preferred loan significantly structured depends on the income and age.
- Subprime loan default resolutions: do they vary across mortgage products and borrower demographic groups?, Voicu, I., Jacob, M., Rengert, K., & Fang, I. (2012). The Journal of Real Estate Finance and Economics, 45(4), 939-964. This paper explores default results for subprime first lien loans that occurred in the recent subprime mortgage flourishing. The investigation of this study took place in two phases. The paper begins by examining issues related to pre-foreclosure results for subprime mortgages in default. Secondly, it examines issues related to different outcomes for loans that enter foreclosure. From the study, the author discovered that the presence of junior liens upsurges the probability of the loan outstanding in default. Owner-occupancy is connected with a lower probability of foreclosure commencement and REO, and greater probability of curing the default.
- Geographic variation in subprime loan features, foreclosures, and prepayments, Rose, M. J. (2013). Review of Economics and Statistics, 95(2), 563-590. This paper examines the effects of geographical variations on the prepayment of penalties balloon mortgages and reduced certification on the likelihood of foreclosure and prepayments. The results of the study indicated that reduced certification on the prepayment of penalty and probabilities of foreclosure are associated with lower probabilities of repayment. The balloon loans and prepayment of penalties are more associated with prepayments.
- Multifamily mortgage credit risk: lessons from recent history, Goldberg, L., & Capone Jr, C. A. (1998). Cityscape, 93-113. This paper explains the multifamily mortgage default using innovative default model. The author provides known factors that affect the family mortgage, but the quantification of such factors has not been conducted. Therefore, the author conducts an innovative analysis to determine how those factors affect the family mortgage. The study develops a model that uses either the borrower or the lender defaulting if the model has negative cash flows or negative equity. Therefore, the study discovered that multifamily credit risks are influenced by factors such as a decline in the tax benefits and lax underwritings.
- The New Deal and the origins of the modern American real estate loan contract, Rose, J. D., & Snowden, K. A. (2013). Explorations in Economic History, 50(4), 548-566. Fully amortized mortgage loan contract is an indispensable financial innovation in the US, especially in the residential mortgage market. This paper examines the adoption of a fully amortized mortgage loan for the US households between the 1880s to the 1930s. The paper further discovered that the conventional loan market is likely to be avoided because B&Ls, unlike other lenders, use federal housing insurance program.
- Budgetary time bombs: controlling government loan guarantees, Baldwin, C., Lessard, D., & Mason, S. (1983). Canadian Public Policy/Analyse de Politiques, 338-346. This paper examines government budgeting that can help control loan guarantees. The author provides that deficiency of federal budget is important because it ignores the expected policy costs that guarantee private borrowing. Even though the guarantee of loan does not grant instant cash spending, but they commit the government to future cash spending the act that makes them very costly. Therefore, the expected costs should be based on proper plans to meet the future spending.
- Mortgage Interest Rates and Points: Practical Advice for Your Clients, Styron, W. J., Basciano, P., & Grayson, J. M. (1995). Tax Notes (December 12).(http://taxprof. Typepad. com/taxprof_blog/files/2005-24073-1. pdf). This paper explores and explain the various concept of interest and provide an in-depth understanding of the interest rate. The paper further provides ways that the households can use when evaluation of the interest rate and loan repayment.
- Mortgage contracts and housing tenure decisions, Chambers, M., Garriga, C., & Schlagenhauf, D. (2007). This paper analyses various mortgages contracts and their impacts on housing investment and tenure decisions using the model that has liquidity constraints and heterogeneous consumers. The study discovered that different types of mortgage contracts impact the household decisions in three dimensions. These dimensions include the payment schedule, the down payment constraint, and the amortization schedule. Contracts with lesser down payment allow the low income and younger households to own houses earlier. On the other hand, mortgage contracts with rising payment schedules improve the first-time buyers` participation but can generate a lower rate of homeownership.
Term default, balloon risk, and credit risk in commercial mortgages, Tu, C. C., & Eppli, M. (2003). Journal of Fixed Income. Balloon risks and term default play a collaborative role in valuing credit risk in commercial mortgages. This paper discusses the pricing models used in the commercial mortgages markets considering both the payment schedule.