- A balloon note is a loan that has an initial period of low, interest-only or interest-and-principal payments, followed by a large lump-sum payment at the end of the term.
- Five- and 10-year terms are standard.
- Balloon notes can be ideal for short-term borrowers.
- Balloon notes can be risky for lenders and borrowers.
What Is a Balloon Note?
A balloon note, sometimes called a balloon loan, doesn’t amortize fully over its term. It only requires the borrower to pay off a fraction of the principal balance in fixed payments over a relatively short period before fulfilling the obligation with a final lump-sum payment due at the end of the term. This last payment, the balloon payment, settles the remaining balance.
Though they have become less popular in modern times, some mortgages are balloon loans. Small payments appeal to homebuyers. Before the balloon payment is due, the homeowner may sell the property, refinance the mortgage or pay the lump sum to cover the balloon payment.
Balloon notes are attractive to short-term borrowers because of their lower monthly payments. However, borrowers need to beware of the challenges of refinancing, including the risk of the loan resetting at a higher interest rate.
How Balloon Loans Differ From Other Loan Types
The one key difference between balloon notes and other loan types is the lump-sum balloon payment at the end of the loan term, but that isn’t the only factor that makes them stand out.
- Fewer Lenders
- Small or private lenders typically offer balloon notes for a specific use, such as for construction. Mortgage lenders typically don’t allow balloon payments for qualified mortgages.
- Stricter Qualification Criteria
- Balloon notes fall into the unqualified mortgages category for which lenders establish their own requirements. These requirements are typically stricter and often require higher down payments and higher credit scores than other mortgages.
- Higher Interest Rates
- Mortgage rates for balloon notes are typically higher because lenders take on more risk.
How Balloon Notes Are Different
Balloon notes aren’t the only loans that don’t conform to a standard amortization schedule and don’t have standard installment payments. A hybrid adjustable-rate mortgage and an interest-only mortgage also have unconventional characteristics. As with balloon notes, these loans usually have higher interest rates.
When Should You Get a Balloon Loan?
In general, balloon notes make sense for short-term borrowers.
Example scenarios in which it makes sense to consider a balloon loan include:
- You expect a lump sum before the balloon payment falls due.
- You expect a significant increase in your income in the near future.
- You only need short-term financing to flip a house in a short time and you intend to sell the property before the lump sum is due.
How Balloon Notes Work
Balloon notes can function in several ways, and the lender often dictates the terms. Balloon notes typically have fixed payments for a defined period, followed by the concluding balloon payment.
- You can erase the balloon payment by getting a new loan with a new repayment period. This approach requires good credit, and prevailing interest rates influence the terms.
- You can pay off the loan balance by selling the property attached to the loan for a profit. One potential risk here is selling for less money than the value of the loan and therefore not having enough to pay the balance on your balloon mortgage.
- You can also pay off the loan as stipulated in the mortgage. This option is not common because most people don’t have the lump sum of cash available to pay the balloon payment.
What Are Your Options When the Balloon Note Is Due?
Lenders don’t amortize these loans in a traditional way. While term lengths can vary, five-year and 10-year balloon mortgages are standard. But lenders often calculate monthly payments as though the loan is a traditional 30-year mortgage, making the monthly payment smaller. Payments can also cover interest only or principal and interest.
There are many examples of how balloon notes can work — and how different terms affect loan balances. A few examples are highlighted in the charts below.
5-Year Balloon Mortgage with Interest-Only Payments
In this example, the $300,000 mortgage is an interest-only loan with a 5% interest rate. Because payments are interest-only, the $300,000 balloon payment is due at the end of the loan term.
|Year||Monthly Payment||Principal Balance at Year End|
10-Year Balloon Mortgage with Principal and Interest Payments
In this example, the $300,000 mortgage is a 30-year loan with a fixed 5% interest rate.
|Year||Monthly Payment||Principal Balance at Year End|
Because payments cover the interest and the principal, the loan balance decreases but not enough to clear the 30-year calculated term in 10 years. A $244,026.19 balloon payment is due at the end of the 10-year term.
How To Sell Your Balloon Note
Balloon notes are negotiable instruments, and you can sell them. There are many options and combinations of options when selling a balloon note.
- Full Sale
- The buyer purchases all remaining payments, including the balloon payment.
- Standard Partial Sale
- This involves the sale of a defined number of future payments for a lump sum now. Upon receiving all the sold payments, the note reverts to the seller, who receives the remaining payments.
- Balloon Cash Out
- The seller receives a discounted lump sum for the balloon payment due in the future and continues to receive all monthly payments.
The most common are:
Although you can sell balloon notes at any point during the loan term, you are likely to have more success selling the further it is from the balloon payment date.
Balloon Note Frequently Asked Questions
Balloon notes are best suited for people who need short-term financing. A real estate investor quickly flipping a property or someone who expects to receive a lump sum shortly after receiving the note might be a fit for this loan type.
It makes sense to sell a balloon note when selling provides increased value to the investor. Selling makes sense when market conditions show that the value of the underlying asset, such as a house, is worth more than the value of the current loan.