Balloon Payment Definition
A balloon payment is a lump sum of money that is paid at the end of a loan term. It is typically used in loans with long repayment periods, such as mortgages or auto loans, and provides an incentive for the borrower to pay off their debt quickly. The borrower will make regular payments on the loan over time, but then face a large final payment at the end of the term that they must make in order to completely pay off the balance owed.
Uses of Balloon Payments
The primary purpose of using balloon payments is to reduce monthly loan payments by deferring part of the amount owed until later in life when it may be easier for borrowers to repay them. This can be beneficial if someone needs low monthly payments during their working years so that they have more disposable income each month but still wants to eventually fully repay what they owe. Additionally, some lenders use balloon payments as an incentive for borrowers who are willing to take on higher interest rates than normal due to their credit history or other factors.
Risks Associated with Balloon Payments
One risk associated with taking out a loan with a balloon payment is that there can be unexpected costs associated with repaying this type of debt at once instead of making smaller installments over time. For example, if interest rates rise significantly between when you initially took out your loan and when you need to make your final payment, then your total cost could be substantially higher than originally anticipated because you’ll have less time available for accruing interest before making your final payment. Additionally, not all lenders allow refinancing options which means borrowers could get stuck paying much larger sums than expected if they don’t plan accordingly or if something changes financially after taking out their original loan agreement (such as job loss).
