Balloon loans commonly are associated with mortgages, but can be structured for a variety of lending scenarios. A balloon loan has one key advantage and one big disadvantage for the borrower. Balloon loans usually have lower payments over the first few years than when the same amount is borrowed using conventional loans. However, the disadvantage is that the borrower may not be in a position to pay the balloon payment when it comes due, which could require refinancing or defaulting on the debt.
Preparing for the Balloon Payment
The lump sum due date can be accompanied with a lot of concern, considering the payment may be 80 percent of the total amount of the loan. For example, the lump sum on a 10-year balloon loan of $250,000 with a 4.5 percent interest would be more than $201,000. If a borrower is not in a position to pay the lump sum, or sell the asset that has secured the loan before the lump sum is due, the remaining option is to refinance the debt. Borrowers planning to refinance should start the application process well in advance of the loan coming due, as the process can take approximately 6 weeks, according to the FHA.
Loans with Built-in Refinancing Options
Refinancing options may be limited if the underlying property has lost value, resulting in little no collateral to secure a new loan. In this situation, any refinancing options that have been built in to the original loan agreement may provide a solution. These backup loans can be structured with long or short maturities and with adjustable or fixed interest rates. Refinancing choices may also include options to take out follow-on balloon loans. If several built-in refinancing options are available, the borrowers should look for a loan that fits their long-term plans.
A borrower who has built equity prior to the lump sum coming due, either in the asset securing the loan or a separate property, may be able to refinance using the collateral as security. The potential advantages of refinancing with a secured loan include the avoidance of another balloon payment in the future, and lower rates than a personal loan for a similar amount. Refinancing with a loan backed by collateral adds additional risk. If the balloon loan is unsecured, there are no assets that the lender can repossess or foreclose. Securing a loan with collateral would put the underlying asset at risk of being forfeited in the event of a default on the loan.
Taking out a New Loan
A borrower who has a history of timely payments on the balloon loan, vehicle and credit card debt over the course of several years probably will have a higher credit score than when the original loan was taken out. A high credit score may allow for the balloon loan to be refinanced with a new loan, even if the attached asset does not have a substantial level of equity.