Balloon Payment refers to the concept of large payment due at the end of a balloon loan. It is a kind of loan intentionally structured with earlier payment during loan terms to be smaller and for later payment often just the last payment to the higher. At the start, the inflows may be fairly low but increases over time. This may balance the loan payment as well. In this blog ahead we will cover some major facts about balloon payment and how it works.
Did You Know? For a loan to be settled under balloon payment, a clause for balloon payment must be stated in the contract of the loan stating the amount.
What is Balloon Payment?
Balloon payment in most simple terms may be put into as a large sum of the loan amount paid at the end of the loan period. But, The amount of the balloon payment must be discounted at the present value based on the interest rate of the loan. Balloon payments are most common in real estate. It is quite preferred that the loan payers refinance their loan as balloon payments get near.
How are Balloon payments calculated?
It is the terms of the loan that provide the amount and interest involved to calculate balloon payments. However, here are a few easy steps to calculate balloon payments -
Step 1: First of all determine the amount of instalments and the amount of interest involved.
Step 2: Calculate the amount due at the end of the year using the rate of interest as discounting factor to discount the number of installments paid till the end of the loan period
Step 3: Reduce the amount determined in step 2 from the amount of principal, There is your Balloon payment at the end of the year.
Step 4: You may also discount the balloon payment to ascertain the implicit rate of return of the loan
Balloon Payments Examples
It is important to understand that Ballon payments are huge sums of money which may put the loan payer under serious financial stress. That is why the balloon payments are restructured by way of a fresh loan involving a shorter period than the original loan. Alternatively, the underlying asset may be sold to finance the balloon payments. However, whatever the arrangements will be, here are a few examples of loans involving balloon payments -
Real estate constitutes one of the highest investments for a middle class family. It generally involves balloon payments at the end of the loan period to settle the accounts. A typical real estate loan last for close to 10 to 15 years, maybe even more and to reduce the financial burden on the house owner, the balloon payment is included so that the amount of installments shrinks. However, this may include more interest payments to the lender.
Under adjusted rate loan, the rate of interest is adjusted with the ongoing market rate of interest on a regular interval twice or thrice within the loan period depending on the terms of the loan.
Balloon payments are not that common when it comes to automobile loans. However, this structure works fine since the automobile is an essential part of the modern lifestyle. An individual pays to purchase a car at a low monthly loan payment and restructures later on to pay the balloon payment. As lending restrictions are at ease in auto loans, it is easy to secure such arrangements.
It is quite easy for a business to secure a balloon loan for business especially since the company has a proven history of not defaulting on installments. Businesses have high liquidity to finance the balloon payment at the end of the loan period. This arrangement may prove to be highly effective in the case of long-term projects like constructing a hydroelectric plant since cash inflow can only be expected after the construction gets completed.
The long-term project becomes highly risky owing to debt financing and only after two to three years, any cash inflow may be expected. In these initial years, more interest amounts may put the company a tight liquidity position. Balloon loans may prove to be highly effective in these type of long projects, reducing the burden of interest.
Advantages of Balloon Payments
There are various benefits of balloon payments, the obvious being low installments during the initial periods of the loan. However, here are a few more benefits of balloon payments -
- During the loan period, the installments are kept low which would otherwise be high in other types of arrangements. This may benefit the borrower if he does not expect a good return presently.
- Though, the scrap value of the underlying asset under a balloon loan may not be sufficient to pay the huge sum. The asset may be sold to generate a portion and restructure the rest
- For others, a Balloon loan may prove to be effective since, at the start of one’s career, compensation is fairly low but increase as the career progresses. This may balance their personal finances.
- Since the installments are kept low, the loan payers are left with more liquidity. the additional funds may be used to pay out the balloon payments.
- Balloon payments are usually for a shorter period. This helps the lending institutions to manage risk
- Since the debt is getting restructured, only hand full of paperwork may be required.
Disadvantages of Balloon Payments
There are multiple disadvantages of balloon loans. However here are a few of them -
- The most obvious disadvantage of balloon loans is that of high interest payments at the start of the loan period
- Effectively, The amount of principal is paid really low at beginning of the loan period
- This may cause a very high cost of borrowing. However, It may be compensated if you expect an income rise in the near future.
- Apart from it, the balloon payments may require to be restructured which will be a short term loan and may involve a high rate of interest from the original loan.
- There always involves a greater risk of foreclosure if funds are not arranged at the end of the period.
- There involves a risk factor for the lender since less and less amount of the principal is recovered initially from the borrower which leads to an increased rate of interest
Just like any other loan balloon payments involve small installments the difference lies in the fact that the amount of payment subsequently is high than the previous installments. The lender usually collects the fund in the same manner by charging the interest amount with every installment and in the final month of payment, a huge sum is required to be paid called balloon payment. There are various benefits and disadvantages of a balloon loan but the benefits may outway its limitations depending on your loan requirements, your personal finances, etc. It is quite effective in the situation of increasing housing prices in India. Apart from this, The installments are kept low so that the loan payer does not feel the burden much. Alright, You have discussed what is balloon payments, how to calculate the amount of balloon payment, its benefits and disadvantages, and a few of its examples. Hope you enjoy reading it so far.
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