'Balloon Loan' is explained in detail and with examples in the Corporate Finance edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
A balloon loan is a kind of loan that does not divide its payments up evenly throughout the life of the loan. These kinds of loans are not fully amortized over the loan’s term. As a result of this, one time balloon payments are mandatory at the end of the loan’s time frame in order to pay off the loan’s remaining principal balance.
Balloon loans have their advantages. They are often appealing to you if you are a short term borrower. This is because balloon loans commonly come with an interest rate that is lower than the interest rate of a longer term loan. These lower interest rates provide a benefit of extremely low interest payments. This leads to not only lower payments throughout the loan, but also incredibly low outlays of capital in the life span of the loan. Because the majority of the loan repayment is put off until the loan payment period’s conclusion, a borrower gains great flexibility in using the capital that is freed up for the term of the loan.
The downsides to these balloon loans only surface when the borrower lacks discipline or falls victim to higher interest rates later on. If a borrower does not possess focused and consistent discipline in getting ready for the large last payment, then the individual may run into trouble at the end of the loan. This is because substantial payments along the way are not being collected. Besides this, if a borrower will be forced to engage in refinancing towards the end, then the borrower may suffer from a higher interest rate on the balloon payment that is rolled forward.
Some balloon loans also include a higher interest rate reset feature later in the life of the loan. This further exposes a borrower to the risk of higher interest rates. This is common with five year types of balloon mortgages. When a reset of the interest rate feature is present at the conclusion of the five year period, then the interest rate will be adjusted to the current rates. The amortization schedule will then be recalculated dependent on a final term of the loan. Balloon options that do not include these reset options, and many that do reset, generally encourage the loan holder to sell the property in advance of the conclusion of the original term of the loan. Otherwise, many borrowers will simply choose to refinance the loan before this point arrives.
The reasons that you might choose to get a balloon loan are several. A person who does not plan to hold onto a house or property for a long period of time would benefit from such a loan arrangement. This individual would plan to resell the house in advance of the loan expiration. Another reason for taking a balloon loan is in a refinancing. Finally, if a person anticipates a significant cash settlement or lump sum award, then they might take on a balloon loan. Commercial property owners often like balloon loans for the purchase of commercial properties as well.
Balloon loans are sometimes called balloon notes or bullet loans.