Back to: BANKING, LENDING, & CREDIT INDUSTRY
Balloon Payment Definition
A balloon payment is huge loan payment due at the end of a balloon term agreed upon between the lender and the borrower. These payments include payment for mortgage loans, commercial loan or amortized loans. A balloon loan always tends to have short term, and only a fraction of the principal balance is amortized over the set period. When the period ends, the remaining principal balance becomes the final repayment.
The term balloon means that since the final repayment is large and ballooned compared to other loan payments. Despite being the short-term repayment, it tends to double the amount of the previous repayment. Nonetheless, the balloon loans are mostly practiced by the commercial lenders compared to consumer lending.
A Little More on Balloon Payments
Balloon payments are always set into two-step mortgages. The balloon mortgage is comprised of the borrower paying back the loan at a set interest rate for a specific term. When the term ends, the interest rate is reset and the payment of the balloon rolls into a new or amortized mortgage at the current interest rates. Due to the existence of some two-step mortgages, the process of loan reset is not automatic. The reset is based on multiple factors, such as timely payment, and consistency of the income. If the reset of the loan does not occur, the balloon payment becomes due.
Besides, most people tend to confuse between adjustable-rate mortgage (ARM) with balloon loan. In the adjustable-rate mortgage, the borrower receives rate at the beginning of the term. The interest can be set at the beginning of the period and may continue to reset periodically until the loan is fully paid. The loans also differ in that, balloon loan does not reset automatically while the ARM reset automatically and the borrower is not compelled to refinance the balloon payment or apply for a new loan. In this regard, the ARM seems to be easy to regulate compared to mortgage loan
In the ARM, the mortgage owner does not incur large balloon payment at the end of the term even if the principal amount remaining at the end of the period is still high. Due to this the mortgage owners and the borrowers make an advance plan to refinance their mortgage or sell their homes before maturity dates. The balloon payment is associated with problems related to fall in the housing market. When the prices of houses decline, the possibility of the homeowners generating positive equity also declines. Therefore, they may not be able to sell their houses at anticipated prices. As such, the buyer may not have any option but to default the loan and be part of foreclosure regardless of their income.
References for Balloon Payment
Academic Research on Balloon Payment
- Money management knowledge of college students, Danes, S. M., & Hira, T. K. (1987). Journal of Student Financial Aid, 17(1), 1. Most of the students in the learning institutions especially, colleges look forward to starting earning form their career. However, most of the curricula put in place put little attention on preparing the students how to manage their earned money effectively. Moreover, many students take up loans to finance their education. In this regard, this paper provides an in-depth understanding and ways that students can use to manage their earned money. The paper further discusses the importance of saving especially by the young families that may not have experience in money management.
- Mortgage Backed Securities, Model, P. P. (1985). This paper presents a pricing formula for MBSs and recommends a particular model for MBS prices that determine the so-called burnout phenomenon of pre-payments due to refinancing. The paper further provides numerical example models demonstrated by Monte Carlo simulation. An estimation procedure is also described.
- Consumer-Credit Legislation: Limitations on Contractual Terms, Helstad, O. L. (1966). BC Indus. & Com. L. Rev., 8, 519. For decades, every government has regulated the conditions through with the consumer is granted a credit to purchase goods and services. This paper discusses the mechanism put in place by the government to regulate the consumer credit. According to the author, the legislation focuses on a particular creditor and various types of transactions related to consumer credit business. Moreover, over the recent period, the states have implemented policies that tend to achieve uniform consumer credits. The author suggests that uniform consumer credit can only be achieved when the government takes control of the whole spectrum of consumer credit.
- The impact of predatory loan terms on subprime foreclosures: The special case of prepayment penalties and balloon payments, Quercia, R. G., Stegman, M. A., & Davis, W. R. (2007). Housing Policy Debate, 18(2), 311-346. For a long period, the has been increased concern on how predatory mortgage erodes the housing equity. In this regard, this paper examines the impacts of abusive loan term and foreclosure. The study used the national database of subprime refinance first‐lien loans in 1999 to examine the impact. From the study, it was revealed that refinance loans with penalties less likely to experience foreclosure compared to balloon payments which highly experience foreclosure. The study also discovered that the predatory loans do affect not only the household wealth but also have negative effects on communities, households, and individuals.
- The Duration of an Adjustable‐Rate Mortgage and the Impact of the Index, Ott Jr, R. A. (1986). The Journal of Finance, 41(4), 923-933. With the increasing use of adjustable‐rate mortgages for asset/liability management, there exists the need to evaluate their price sensitivity to interest rate changes properly. This paper provides a foundation by deriving the duration of an adjustable‐rate mortgage. The properties of this duration are unique and have some important differences from those of fixed‐rate securities. One important characteristic of an adjustable‐rate mortgage concerns the index used to adjust the mortgage rate. It was found that the index tended to be more important than the adjustment frequency in determining the duration of an adjustable‐rate mortgage.
- Mortgage prepayment with an uncertain holding period, Yang, T. T., & Maris, B. A. (1996). The Journal of Real Estate Finance and Economics, 12(2), 179-194. This paper explores the pricing model that is used to value mortgage and prepayment options. The author presents that the effective mortgage life is a random variable with a known probability. The model can be applied when the ex-ante expectation of the borrower`s tenure follow any probability distribution. The pricing model is used to determine the conditions for the optional financially motivated prepayment.
- Understanding the subprime mortgage crisis, Demyanyk, Y., & Van Hemert, O. (2009). The Review of Financial Studies, 24(6), 1848-1880. This paper explores and provides an in-depth understanding of the financial crisis associated with subprime mortgage loans. Mortgage loans, through adjusting performance for a different borrower, loan and economic characteristics. The discovered that the quality of loan deteriorated over the loan term was aware of their effects. The author provides the evidence that the rise and fall of the subprime loans follow the lending boom-bust scenario, whereby unsustainable growth leads to the collapse of the market.
- The failure and promise of mandated consumer mortgage disclosures: Evidence from qualitative interviews and a controlled experiment with mortgage borrowers, Lacko, J. M., & Pappalardo, J. K. (2010). American Economic Review, 100(2), 516-21. This paper presents that the availability of consumer credit is affected by the policy responses to mortgage default, delinquency, and foreclosure. The author suggests that adoption of cost-benefit policy will significantly help reduce the consumer credit crisis. However, the consumers are faced with the problem of lack of disclosure information about key costs and risks of their mortgages. The author also discovered that the failure of mandated disclosures to convey mortgage information to borrowers does not occur due to the irrationality of the consumers or complexities that occurs in the new mortgages.
- An overview of the predatory mortgage lending process, Renuart, E. (2004). Housing Policy Debate, 15(3), 467-502. This paper presents an overview of the predatory lending process. It explores the structure of the larger mortgage lending market and explains how predatory lending fits into it. The paper starts by describing the mortgage marketplace and its players. After that, it explores the differences among subprime, prime and predatory segments of the market especially their relationship to pricing, risks and borrower characteristics. The study concluded by summarizing the observation about the objectives and how the lenders undermine the borrower`s wealth building capacity.
- Pricing commercial mortgages and their mortgage-backed securities, Kau, J. B., Keenan, D. C., Muller, W. J., & Epperson, J. F. (1990). The Journal of Real Estate Finance and Economics, 3(4), 333-356. This paper tends to present accurate modeling of the complex commercial mortgage and the mortgage-backed security. Moreover, it critically provides a comprehensive set of numerical models for valuation of mortgage-backed. The paper the concluded that option pricing provides a flexible and accurate approach to valuation of complex mortgage instruments in the face of the developed financial community.
- Mortgage innovation, mortgage choice, and housing decisions, Chambers, M. S., Garriga, C., & Schlagenhauf, D. (2008). Federal Reserve Bank of St. Louis Review, 90(6), 585-608. This paper explores the mortgage products introduced recently and available to the consumers. The authors explain how these products vary across important characteristics, such as repayment structure, the down payment requirement, and amortization schedule. The article also presents a model that analyze the implications for various mortgage contracts for the households. The model also addresses the issues that occur in the current market. The author also examines the impacts of alternative mortgages for homeownership. Using the model, the model, the author suggests that adjustable interest rate and combo loans aid in explaining the rise and fall in the homeownership.
The financialization of home and the mortgage market crisis, Aalbers, M. B. (2016). The Financialization of Housing(pp. 40-63). Routledge. This paper examines the financialization of the home and the mortgage market crisis. According to the author, mortgage markets are a special kind of financial market. They are designed as credit markets enhancing capital switching to the secondary circuit of capital. This paper pays consideration to the geographical variances in the financialization of home, but a fuller account of how space interconnects with the political economy of mortgage markets and the financialization of proprietors remains a task for the future.