What is Balloon Payment – Its Examples and How It Benefits the Borrowers?
Balloon payment is a lump sum payment towards a loan that is significantly higher than regular monthly instalments. This inflated payment size has led to the use of the term ‘balloon’ for them. All types of loan borrowers can opt for this payment. However, it is more common in commercial borrowing, where commercial establishments pay large balloon payments to reduce their loan burden.
Read on to understand why balloon payments are beneficial, the eligibility criteria and risks involved.
How Does Balloon Payments Work?
A balloon loan is different from an amortised loan. Under an amortised loan, you need to repay the amount by paying equated monthly instalments. However, in case of a balloon loan, you are required to pay a uniform amount throughout loan tenure, and at the end of tenure, you opt for a large payment known as a balloon payment.
These payments are more common in short-term loans of 5 to 10 years. Making a bulk payment towards the end of a short-term loan to close it goes a long way in helping the borrowers.
Any sort of mortgage loan can become a balloon loan. During the initial days of your loan repayment, you pay a fixed payment which may be the interest component only. Towards the end, you repay a chunk of the loan amount, which could basically be the principal component.
Why Are Balloon Payments Beneficial?
Here are some benefits of balloon payments:
1. Small Monthly Payments
Small regular payments in a balloon loan lower the burden on borrowers. Moreover, the cash that they save by paying small amounts can be invested in another sphere to earn handsome returns and further the process of capital accumulation.
2. Offers More Time
In case of a balloon loan, borrowers get additional time to manage their loans. As borrowers know the exact bulk payment that they need to make towards the end of loan tenure, they can start investing some amount which will create wealth and help them pay off loans more easily.
3. Short-term
Balloon payments are generally made for short-term loans. It is ideal for those who are expecting a lump sum amount after a specific time period, like a seasonal worker who may receive a hefty amount at the end of the business season. He/she can opt for a loan and use the lump sum amount as a balloon payment.
What Are the Eligibility Criteria for Balloon Payment Lending?
Balloon loans can be quite a risky venture for lenders. Therefore, they have put stringent conditions that you must fulfil before opting for balloon payments:
- The borrower must have a high credit score, preferably above 750. However, it may vary from one lending institution to another.
- Borrowers must have a stable income stream either via salary or business. This is done to ensure that you have the capacity to make a large balloon payment at the end to close the loan.
- High-valued collateral is also mandatory when opting for mortgage loans. It acts as a safety net for bankers.
- The borrower must be between the working age, i.e., 21 to 60 years.
Example of Balloon Payment
Let’s consider a balloon payment example that will help in understanding this concept more easily:
Suppose a company is aggressively working on developing a new product. However, research and development will entail huge investments. In this scenario, a balloon loan can be an ideal solution.
As the initial payments will be small, the business will not get burdened by repayment schedules during the development years and early operational years. However, when the product gets good business in later years, it will generate enough profits, a part of which can be used to make a balloon payment and close off the loan.
This is how balloon payments help a business manage its finances without getting overburdened and remove the threat of default. Moreover, many financial institutions allow borrowers to modify the repayment conditions to suit their business needs.
Risks Involved with Balloon Payments
Some of the limitations or cons of a balloon payment are as follows:
- You may not be able to foreclose this loan if you do not satisfy loan conditions.
- Balloon loans and subsequent payments come with stringent eligibility conditions. Hence, it may be out of bounds for a large percentage of borrowers.
- The interest rate charged by lenders on these loans is much higher than traditional amortisation loans. A higher interest rate offsets the risk taken by lenders during lower initial repayments.
Important Points and Relations of Balloon Payments
Some important points related to balloon payment mortgages are as follows:
- Constant Payment: There is a linear relationship between balloon payments and the size of constant payments. A rise in constant payment will lead to a linear fall all the way to zero for balloon payments. When these payments are at zero level, constant payment will be equivalent to an instalment of an identical amortised loan.
- Interest Rate: There is a non-linear relationship between balloon payment and interest rates. A rise in the interest rate on loans will increase the value of balloon payments quite significantly. Therefore, in order to reduce the size of balloon payments in the wake of rising interest rates, borrowers must pay a higher amount of constant payment. This may lead to the financial destabilisation of a borrowing company.
Final Word
A balloon payment is an efficient financial tool that helps borrowers lower the burden imposed by loans by paying a bulk amount towards the end. This is beneficial for individuals or corporates who are expecting significant cash flows at a later stage. Individuals should make sure to plan their future finances efficiently before opting for a balloon loan.
To get a home loan at attractive interest rates and flexible EMI options in a 100% paperless manner, download the Navi App now!
FAQs
Ans: There are several options that you can exercise to finance balloon payments. This includes selling an underlying asset equivalent to the payment amount, refinancing the loan with fresh repayment terms or transferring it to another lender altogether.
Ans: The effectiveness of a balloon payment depends on your prevailing financial situation. If you are expecting sufficient cash flows after a certain time period, you can opt for these loans. However, if you are not confident about making that bulk payment, you can try a traditional loan.
Ans: In case of traditional loans, the APR or financing charges will be lower than in balloon loans. It is because the latter is riskier for lenders. Moreover, in balloon loans, borrowers pay lesser amounts in monthly instalments as compared to a traditional loan.
Ans: A deposit payment is a lump sum amount that a borrower pays to the lender after the initiation of a home loan or mortgage loan. On the other hand, a balloon payment is a bulk payment paid to the lender at the end of the repayment tenure.
Before you go…
Are you looking to buy that house you’ve been eyeing 🏠 and you need a loan of up to ₹5 crore. Install the Navi app now and get instant in-principle approval right away! Interest rates starting at 8.60% p.a.
Disclaimer: This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
Home Loan Knowledge Base
