A balloon loan refers to a large payment or a balloon payment towards maturity, often associated with a mortgage loan. It is usually a short-term loan with lower as well as fixed rates of interest. A balloon loan starts with extremely low payments of interest thus needing very less capital outlay during the tenure of the loan. Major part of the repayment is postponed until the borrower reaches the end of the payment period. In this way, the borrower enjoys a great deal of flexibility for utilizing the capital that is available throughout the period the loan is carried. Balloon loans are usually undertaken during refinancing or huge anticipatory cash flow. It is also called bullet loan or balloon note.
Balloon loans are generally reserved by business houses. Individuals in the business of real estate or those involved in flipping properties find it beneficial to go for this type of loan.
Is a balloon loan more advantageous than an adjustable rate mortgage?
In quite a few aspects, a balloon loan is similar to a 30-year fixed-rate mortgage (FRM). In both situations, the total payment is the amount necessary to pay off the loan fully over thirty years. The difference between the two instruments lies in the fact that after five or seven years, the outstanding amount (balloon) needs to be paid off in full.
A seven year balloon loan can be compared to a seven year adjustable rate mortgage (ARM) with the starting rate period akin to the balloon period. Both come with a constant rate till seven years, subsequent to which the rate is adjusted.
There are certain advantages of taking a seven year balloon loan over a seven year ARM. The balloon loan is relatively simpler in the sense that; you can pay off the amount by refinancing. The new loan comes with the rate of interest prevailing in the market at that time. On the other hand, an ARM borrower has to deal with a rate adjustment that has already been announced at the time of signing the contract, which several borrowers may find tough to comprehend.
Another advantage of a balloon loan is that lenders usually charge lower rate of interest due to the reason that this rate can be wholly adjusted with the market after a period of seven years. In case of an ARM, there stands a limitation to the adjustment on account of interest rate caps.
The advantages with ARM can also not be ignored. The ARM offers a guard against future interest rate hike which though unlikely may happen. Another advantage of ARM is that the borrower does not suffer penalty if his credit history has deteriorated over a period of seven years since the deal has been done. In balloon contracts however, the lender does not have any refinance obligation if the borrower has a poor credit history. It is upon the borrower to decide whether the balloon loan suits him or not looking at the ultimate usage of the loan.