Updated: Oct 4, 2020
What is a Balloon Payment Mortgage ? A Balloon Payment Mortgage is a loan that does not fully amortize over the term of loan, which means there is still principal outstanding on the loan maturity/end of loan tenor. Since the outstanding payment on loan maturity is significant, hence its termed as balloon. Balloon payment mortgages are more common in commercial real estate than in residential real estate.
Reading Suggestion:Criteria to avail covid loan for small business
Description A Balloon Payment Mortgage is applicable in both, fixed as well as floating interest rate regime. If N is the tenor in which loan is amortized and M is the tenor in which principal outstanding is due then Balloon payment Mortgage is defined as M due in N. Inclusion of a balloon payment facility to a loan, enables the borrower to save on monthly EMI payments, which is made possible since the entire loan is not amortized.
Let’s understand with an example
Example: Mr. X has availed a loan of 10 Million (1 Crore) for 10 years @ ROI of 7%.
Scenario 1 -Normal Payment Mortgage -Under normal course Mr X is required to pay off his loan in 10 years @ EMI of Rs 1,16,108 per month.
Total Amount paid-1,39,33,057
Total Interest Paid- 39,33,057
Must Read :Pradhan Mantri Awas Yojna
Scenario 2-Balloon Payment Mortgage – Loan tenor is 10 years which is amortized over 30 years. In this scenario Monthly EMI payment would be Rs 66,530
Total Amount paid in 10 years-79,83,600
Total Principal Paid in 10 years- Rs 14,18,762
Total Interest paid in 10 years-65,64,838
Principal Outstanding at the end of 10 years- Rs 85,81,238
Hence in this case, the borrower would be required to pay the outstanding principal at the end of 10 years, which is known as Balloon Payment.
Also Check us on You Tube :INDIAN INTELLECTUAL
As evident in the above example, while monthly EMI is lower in balloon payment mortgage, the total interest out flow is on higher side and hence the cost of loan is high.
Customers find it convenient to make a balloon payment, especially those who do seasonal jobs or are expecting strong cash flows before the loan term expires. However, if they are unable to make that payment then they might have to forgo the payment made in the past and return the product or look at refinancing by taking another loan.
Balloon mortgages allow qualified homebuyers to finance their homes with low monthly mortgage payments. A common example of a balloon mortgage is the interest-only home loan, which enables homeowners to defer paying down principal for 5 to 10 years and instead make solely interest payments.
Interest-only and other balloon mortgages are typically used by high networth borrowers who have enough capital to afford paying down a large principal. Most borrowers of balloon mortgages don't actually make the balloon payment when the low payment period ends. Rather, to avoid paying the large lump sum in cash, it's common to refinance into a different mortgage or sell the house.
Balloon loans are a complex financial product and should only be used by qualified income-stable borrowers. For example, this type of loan would be a good choice for the investor who wishes to minimize short term loan costs to free up capital. For businesses, balloon loans can be used by companies who have immediate financing needs and predictable future income.
For the average borrower, it's risky to take out a balloon loan with the assumption that your future income will grow. If you're looking to purchase a house or a car, a better choice would be to make a monthly budget and take out a loan that you can pay on your current income. Alternatively, you can save for a bigger down payment if you're not in a rush to make a purchase—which will let you purchase a more expensive asset with lower monthly payment.
· Lower monthly payments than traditional loans
· Enables borrowers to access affordable short-term capital
· Can help cover financing gaps
· Costs of loan can be higher in the long term, especially if the loan is interest only.
· Poses more risk than traditional loans due to payment schedule
· Higher risk due to lump sum payment
· Usually restricted to most creditworthy and income stable borrower,
· There's no guarantee that you'll be granted a refinance to switch the debt obligation