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Main Findings
Balloon loans are a type of loan that requires a large one-time payment at the end of the term to repay the remaining balance of the loan. Balloon loans typically have lower monthly payments than fully amortized loans because they defer a portion of the principal repayment to the end of the term.
A balloon payment is a large, lump-sum payment that is due at the end of a loan term.
The balloon payment is different from a fully amortized loan, where the loan is paid back in small, equal payments throughout the loan term. A balloon payment is usually much larger than the regular payments, and it can be tens of thousands of dollars or more.
Why use a balloon payment?
A balloon payment can be used to reduce the monthly payments on a loan, making it more affordable for the borrower in the short term. However, this also means that the borrower will have to pay a large amount at the end of the loan term, which can be risky if they do not have enough savings or income to cover it.
A balloon payment can also be used to finance a project that will generate cash flows in the future, such as a business expansion or a new product development. In this case, the borrower can use the future earnings to pay off the balloon payment.
Formula for balloon payment
The formula for calculating the balloon payment depends on whether the loan is a balloon loan or a fully amortized loan with a balloon payment.
For a balloon loan, where the regular payments do not cover the interest and principal of the loan, the formula for the balloon payment is:
BP = A * (1 + i)^n - CP * [(1 + i)^n - 1] / i
Where:
- BP = Balloon payment
- A = Loan amount
- i = Periodic interest rate
- n = Number of periods
- CP = Constant payment
For a fully amortized loan with a balloon payment, where the regular payments cover part of the interest and principal of the loan, and the balloon payment covers the remaining balance, the formula for the balloon payment is:
BP = A * (1 + i)^nb - CP * [(1 + i)^nb - 1] / i
Where:
- BP = Balloon payment
- A = Loan amount
- i = Periodic interest rate
- nb = Number of periods before the balloon payment
- CP = Constant payment
How to calculate balloon payment
To calculate the balloon payment, we need to first find the constant payment using the following formula:
CP = (A * i * (1 + i)^n) / ((1 + i)^n - 1)
Then, we can use one of the formulas above to find the balloon payment, depending on whether it is a balloon loan or a fully amortized loan with a balloon payment.
Examples of a balloon payment
Let's look at some examples of how to calculate the balloon payment using Excel.
Example 1: Balloon loan
Suppose you borrow $200,000 at a 6% annual interest rate for 10 years. The loan is a balloon loan, meaning that you only pay interest every month, and you have to pay the principal amount as a balloon payment at the end of 10 years. What is your monthly payment and what is your balloon payment?
Solution:
1. To find the monthly payment, we use the formula:
CP = (A * i * (1 + i)^n) / ((1 + i)^n - 1)
Where:
- A = $200,000
- i = 6% / 12 = 0.005
- n = 10 * 12 = 120
Plugging these values into Excel, we get:
CP = ($200,000 * 0.005 * (1 + 0.005)^120) / ((1 + 0.005)^120 - 1)
CP = $1000
This means that you have to pay $1000 every month for 10 years.
2. To find the balloon payment, we use the formula:
BP = A * (1 + i)^n - CP * [(1 + i)^n - 1] / i
Where:
- A = $200,000
- i = 0.005
- n = 120
- CP = $1000
Plugging these values into Excel, we get:
BP = $200,000 * (1 + 0.005)^120 - $1000 * [(1 + 0.005)^120 - 1] / 0.005
BP = $184,597.25
This means that you have to pay $184,597.25 as a balloon payment at the end of 10 years.
Example 2: Fully amortized loan with a balloon payment
Suppose you borrow $200,000 at a 6% annual interest rate for 10 years. The loan is a fully amortized loan with a balloon payment, meaning that you pay part of the principal and interest every month, and you have to pay a smaller amount as a balloon payment at the end of 10 years.
The monthly payments are calculated based on a 30-year amortization schedule, but the loan term is only 10 years. What is your monthly payment and what is your balloon payment?
Solution:
1. To find the monthly payment, we use the formula:
CP = (A * i * (1 + i)^n) / ((1 + i)^n - 1)
Where:
- A = $200,000
- i = 6% / 12 = 0.005
- n = 30 * 12 = 360
Plugging these values into Excel, we get:
CP = ($200,000 * 0.005 * (1 + 0.005)^360) / ((1 + 0.005)^360 - 1)
CP = $1199.10
This means that you have to pay $1199.10 every month for 10 years.
2. To find the balloon payment, we use the formula:
BP = A * (1 + i)^nb - CP * [(1 + i)^nb - 1] / i
Where:
- A = $200,000
- i = 0.005
- nb = 10 * 12 = 120
- CP = $1199.10
Plugging these values into Excel, we get:
BP = $200,000 * (1 + 0.005)^120 - $1199.10 * [(1 + 0.005)^120 - 1] / 0.005
BP = $139,509.76
This means that you have to pay $139,509.76 as a balloon payment at the end of 10 years.
Examples
Let's look at some examples of balloon loans and how they work.
Example 1
A homebuyer takes out a 30-year mortgage of $200,000 with a 5% interest rate. The monthly payments are calculated based on a 30-year amortization schedule, but the loan requires a balloon payment of the outstanding balance after 10 years.
The monthly payment for the first 10 years is $1,073.64, and the remaining balance after 10 years is $162,435.90. The homebuyer must either pay this amount in full, refinance the loan, or sell the house before the balloon payment is due.
Example 2
A car buyer takes out a 5-year loan of $20,000 with a 4% interest rate. The monthly payments are calculated based on a 5-year amortization schedule, but the loan requires a balloon payment of 40% of the principal after 3 years.
The monthly payment for the first 3 years is $368.33, and the balloon payment after 3 years is $8,000. The car buyer must either pay this amount in full, refinance the loan, or trade in the car before the balloon payment is due.
Example 3
A business owner takes out a 7-year loan of $100,000 with a 6% interest rate to finance a project. The monthly payments are calculated based on a 7-year amortization schedule, but the loan requires a balloon payment of 50% of the principal after 5 years.
The monthly payment for the first 5 years is $1,432.86, and the balloon payment after 5 years is $50,000. The business owner must either pay this amount in full, refinance the loan, or use the project's cash flows to cover the balloon payment before it is due.
Limitations
Balloon loans have some limitations that borrowers should be aware of before choosing this type of financing. Some of these limitations are:
Balloon loans are risky for borrowers who may not be able to make the large lump-sum payment at the end of the term. If the borrower's income, credit, or property value changes unfavorably, they may not be able to refinance or sell their asset to pay off the balloon payment. This could result in default, foreclosure, or repossession.
Balloon loans may have higher interest rates than comparable fully amortized loans because lenders charge a premium for the risk of lending money for a longer term than they receive payments. The total interest paid over the life of a balloon loan may be higher than that of a fully amortized loan with the same term and interest rate.
Balloon loans may have prepayment penalties that discourage borrowers from paying off their loans early or refinancing before the balloon payment is due. Prepayment penalties are fees that lenders charge borrowers for paying off their loans ahead of schedule. They are designed to protect lenders from losing interest income and to compensate them for the risk of reinvesting their money at lower rates.
Conclusion
Balloon loans are a type of loan that requires a large one-time payment at the end of the term to repay the remaining balance of the loan. Balloon loans can be used for various purposes, such as buying a home, a car, or financing a business project.
Balloon loans typically have lower monthly payments than fully amortized loans because they defer a portion of the principal repayment to the end of the term. However, balloon loans also have higher interest rates and carry more risk for borrowers who may not be able to afford or refinance the balloon payment when it is due.
References
- Investopedia (2023). Balloon Loan: What It Is, How It Works, Example, and Pros & Cons. https://www.investopedia.com/terms/b/balloonloan.asp
- Investopedia (2023). Balloon Payment: What It Is, How It Works, Examples, Pros and Cons. https://www.investopedia.com/terms/b/balloon-payment.asp
- Corporate Finance Institute (2023). Balloon Payment - Definition, Formula, Calculate. https://corporatefinanceinstitute.com/resources/commercial-lending/balloon-payment/
- Consumer Financial Protection Bureau (2020). What is a balloon payment? When is one allowed? https://www.consumerfinance.gov/ask-cfpb/what-is-a-balloon-payment-when-is-one-allowed-en-104/
- Capital One (2023). What Is a Balloon Payment? https://www.capitalone.com/learn-grow/money-management/balloon-payment/
FAQ
A balloon payment is a large, lump-sum payment made at the end of a loan term. It’s often used in short-term loans where the borrower pays only the interest on the principal balance, with the remaining balance due as the final payment.
The primary risk is the ability to make the large lump sum payment at the end of the loan term. If the borrower cannot make this payment, they may need to refinance the loan, sell the asset, or face foreclosure or repossession.
A balloon payment can lower the total cost of a loan if the borrower can afford to make the large final payment. However, if the borrower cannot make the balloon payment and needs to refinance, the total cost of the loan may increase due to additional interest payments.
Yes, if a borrower cannot make the balloon payment at the end of the term, they may have the option to refinance the loan. However, this depends on their creditworthiness at the time of refinancing.
Balloon payments are often associated with mortgages, particularly commercial real estate loans and certain types of auto loans. They’re also common in short-term loans and certain types of business financing.
