Balloon Payments Explained – What You Need to Know for Your Mortgage

Key Takeaways

• If someone has a mortgage that includes a balloon payment, their final payment will be larger than the monthly payments leading up to it.

• The balloon payment is also fairly common in commercial lending, permitting such a lender to keep short-term expenses down and cover the balloon payment with future earnings.

• Individual homebuyers who have a balloon loan generally seek to keep their near-term costs reduced while presuming that their income will have risen by the time the balloon payment is due.

Investors in real estate and those seeking to enter the market would do well to understand “balloon payment,” since it holds potential for mortgage refinancing as well as lower monthly payments – pending eligibility. 

But what exactly are balloon payments? Here is what needs to be known.

What is a Balloon Payment?

A balloon payment is one that is larger than usual – it “balloons” — at the loan term’s end. In other words, if someone has a mortgage that includes a balloon payment, their final payment will be larger than the monthly payments leading up to it. This arrangement is called a balloon loan. 

Payments made before the final one may be all, or nearly all, loan interest, with the balloon payment being the loan principal. 

Note that while the focus here is on mortgages and real estate, a balloon debt structure can be used for any debt type, including auto and business loans.

Why Would Someone opt for a Balloon Payment?

After the 2007-2008 financial crisis, the balloon loan was more often used with business loans. Such a loan can be used to finance a project, providing the borrower with relatively low payments early on. The balloon payment is not due until the project is generating returns on the investment.   

The balloon payment is also fairly common in commercial lending, permitting lenders to keep short-term expenses down and cover the balloon payment with future earnings. 

Likewise, individual homebuyers who have a balloon loan generally seek to keep their near-term costs reduced while presuming that their income will have risen by the time the balloon payment is due. Or they are assuming that they can sell the property and repay the whole mortgage before the balloon payment is due.

How Long is the Loan Term in a Balloon Payment?

Whereas traditional mortgages are for 15 or 30 years, balloon mortgage lenders favor terms of five to 10 years. Why? Because banks generally do not wish to wait until the last payment over so many years to recoup their money.

Who Can Receive a Balloon Payment?

Not everyone is afforded the opportunity to enjoy interest-only payments throughout most of the loan’s life. In fact, such mortgages are generally only available to high-net-worth investors and homebuyers who can, if necessary, handle a higher down payment. Most individuals who seek this type of mortgage also have high credit worthiness and usually plan to refinance before it is time to make the balloon payment.   

Advantages of Balloon Payments

There are advantages to balloon payments, namely the low initial payments, which are generally less than a fully amortized loan payment. The expectation is that as the borrower’s salary goes up, their debt load will also increase.

Securing a balloon loan may also mean fewer transaction fees or administrative costs relative to other loans, because of a shorter underwriting process. Also, because balloon mortgages frequently do not require a home appraisal, borrowers generally do not have to provide as much documentation.  Moreover, the balloon payment can be paid by refinancing the loan — if the borrower meets lender requirements regarding credit and income.

Those who “flip” houses – buy properties to renovate and quickly sell them – often seek such loans because of the lower earlier monthly payments. This permits them to have resources for other purposes.

Regarding risks, balloon payments can become problematic in a declining housing market (which the U.S. is not currently in). As home prices fall, it may be challenging for homeowners to be able to sell their property for a high enough price to cover the balloon payment – if they can sell at any price in time.

This means that home flippers could wind up being locked into a high-interest rate loan if sales become stagnant.

If they have a looming balloon payment they cannot afford, borrowers are sometimes forced to default on their loans and go into foreclosure, which results in the loss of the home.

Also, depending on the amount of paid-off equity one has, balloon mortgages may be challenging to refinance. Because these loans may only pay interest initially, the homeowner may have little equity in the property – if at all – despite making consistent payments over the years.  

In addition, balloon mortgages are generally harder to qualify for, as deferred principal payments cause lenders to seek out borrowers with a high down payment or high credit score. A higher risk for lenders usually means higher interest rates for balloon debt. 

Balloon Payments vs. Other Loan Structures

There are differences between balloon payments and other common loan structures. Balloon mortgages are short-term loans that start with a series of fixed monthly payments over several years and conclude with a final, lump-sum payment that is frequently at least twice as much as the previous ones.

In a traditional interest-only loan structure, the borrower only makes payments toward the interest. This means the borrower is not repaying the loan principal – the money that was borrowed.

With a traditional amortizing loan, the borrower must pay periodic fixed payments that are applied to the principal as well as interest until the loan is wholly repaid. At the start of the loan, the borrower can expect to put out more in interest than in principal. Toward the end of the loan, that reverses. 

Using a Balloon Payment to Invest in Real Estate 

Investors may encounter a balloon payment structure as a financing option when putting capital in real estate, which remains popular for its many benefits, that can include protection against inflation and portfolio volatility, as well as possible steady cash flow, leverage, tax favorability and income streams. 

If investors have a thorough understanding of what balloon payments are, and how they can be used to their benefit, they may be able to invest in some of Yieldstreet’s accessible real estate offerings. The leading platform for “alternative” investments – those other than stocks and bonds – has offerings that include private as well as commercial real estate opportunities – plus a Growth & Income real estate investment trust.  

After all, adding real estate to one’s portfolio can diversify investor holdings, which can mitigate overall portfolio risk. Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Alternative Investments and Portfolio Diversification

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

While there are considerations, and one must qualify, securing a balloon loan can lower one’s monthly payments leading up to the final one, the savings of which can be used to further invest.  It also can potentially facilitate mortgage refinancing.