Balloon Payment - Explained
What is a Balloon Payment?
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Table of ContentsWhat is a Balloon Payment?How Do Balloon Payments Work?
What is a Balloon Payment?
A balloon payment is huge loan payment due at the end of a balloon term agreed upon between the lender and the borrower. These payments include payment for mortgage loans, commercial loan or amortized loans. A balloon loan always tends to have short term, and only a fraction of the principal balance is amortized over the set period. When the period ends, the remaining principal balance becomes the final repayment. The term balloon means that since the final repayment is large and ballooned compared to other loan payments. Despite being the short-term repayment, it tends to double the amount of the previous repayment. Nonetheless, the balloon loans are mostly practiced by the commercial lenders compared to consumer lending.
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How Do Balloon Payments Work?
Balloon payments are always set into two-step mortgages. The balloon mortgage is comprised of the borrower paying back the loan at a set interest rate for a specific term. When the term ends, the interest rate is reset and the payment of the balloon rolls into a new or amortized mortgage at the current interest rates. Due to the existence of some two-step mortgages, the process of loan reset is not automatic. The reset is based on multiple factors, such as timely payment, and consistency of the income. If the reset of the loan does not occur, the balloon payment becomes due. Besides, most people tend to confuse between adjustable-rate mortgage (ARM) with balloon loan. In the adjustable-rate mortgage, the borrower receives rate at the beginning of the term. The interest can be set at the beginning of the period and may continue to reset periodically until the loan is fully paid. The loans also differ in that, balloon loan does not reset automatically while the ARM reset automatically and the borrower is not compelled to refinance the balloon payment or apply for a new loan. In this regard, the ARM seems to be easy to regulate compared to mortgage loan In the ARM, the mortgage owner does not incur large balloon payment at the end of the term even if the principal amount remaining at the end of the period is still high. Due to this the mortgage owners and the borrowers make an advance plan to refinance their mortgage or sell their homes before maturity dates. The balloon payment is associated with problems related to fall in the housing market. When the prices of houses decline, the possibility of the homeowners generating positive equity also declines. Therefore, they may not be able to sell their houses at anticipated prices. As such, the buyer may not have any option but to default the loan and be part of foreclosure regardless of their income.