How a Balloon Payment Works

By Wendy Connick Markets Fool.com

Balloon loans have a bit of a shady reputation these days. Many experts blame balloon mortgages for causing the Great Recession that began in 2008, which leaves a lot of people wondering what a balloon loan is, exactly, and how it could possibly cause a recession.

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Balloon loans are loans that only require borrowers to pay interest for the first few years. In other words, unlike with a traditional loan where you're paying partly interest and partly principal (the money you borrowed) every month, with a balloon loan you'd pay only the interest that's accrued on the loan. Naturally, that results in a much smaller payment than a traditional loan. Balloon structures are typically used for mortgages, but are sometimes available for other types of large loans such as auto loans.

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The trouble with balloon loans

The problem with balloon loans is that eventually the other shoe has to drop. The lender will want you to pay off the principal at some point, typically three to seven years after taking out the loan. And when the deadline comes up, you'll have to pay the entire loan off in one giant payment (aka the balloon payment). A balloon payment can easily be tens of thousands of dollars or more, which is not exactly easy to pay off in one bite.

The other drawback with a balloon mortgage is that because you're paying only the interest on the loan, you never build up equity in the house. Equity can be a great resource for any homeowner; it provides you an emergency source of funding (usually accessed through a HELOC -- home equity line of credit -- or home loan) and helps to ensure you'll get a nice chunk of cash when you sell the house, since a traditional mortgage shrinks over time as you make payments. A borrower with a balloon mortgage has no such resources.

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Why people choose balloon loans

Lenders usually promote balloon loans by arguing that you can simply refinance the loan or sell the house before the balloon payment comes due. That is indeed a possibility, but what if you can't manage either of those escape routes? What if the housing market dries up so that no one's buying, or the value of the house drops so that you can't sell it for enough to cover the balloon payment? What if you lose your job, or your credit score tanks to the point where you can no longer get a new loan to refinance the old one?

These issues were exactly what borrowers faced in 2008. Widespread layoffs combined with sinking home values effectively trapped huge numbers of buyers in their balloon loans. When they could neither sell nor refinance nor make their balloon payments, these borrowers went into foreclosure and lost their homes. The banks couldn't sell the houses either (sinking home values, remember?), and the huge losses they suffered as a result torpedoed the banking system and the U.S. economy with it.

All in all, balloon loans are riskier than traditional loans. If you want to keep your housing costs pared down to the bone, and you're sure you can get out before the balloon payment comes due, a balloon mortgage may be a good choice for you. However, if your situation is less than secure or if you are likely to lie awake worrying that you'll be unable to refinance or move in time, stick with a traditional loan instead.

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