3 Reasons to Think Twice Before Committing to a Loan With a Balloon Payment

Given today's low interest rates, a balloon loan rarely makes sense.

Recently, I read about people (and organizations) taking out loans with balloon payments, and frankly, I felt like I was back in the late 1980s. Unless a loan with a balloon payment saves you money in the long run, it rarely makes sense. Here's why.

How does a balloon loan work? 

Let's say you need a loan for a house, land, RV, or another significant expense. The average interest rate is 12.50%, but the lender offers you a balloon loan. If you accept the offer, your interest rate will be lower (possibly much lower), and your monthly payment will be more manageable. You'll make the lower payment for a set number of years -- typically around five.

However, your monthly payments may not pay down the loan principal, depending on how the loan is structured. For example:

• Some balloon loans are non-amortized, meaning you're paying interest only, and nothing is applied to the principal. If you borrowed $200,000, you still owe the entire $200,000 when the balloon comes due. Plus, you're out any fees you've paid.
• Some are structured so a small portion of your monthly payment goes toward the principal, but the bulk still covers interest. 

Why do people opt for balloon loans?

Imagine that a couple buys a tricked-out RV and plans to travel the country and blog about their experience. To buy the RV, they need to borrow $200,000. They're offered a loan with an APR of 11%. 

The couple agrees that they cannot afford the monthly payment at 11%, so they look into a 5-year balloon loan with a much lower interest rate and monthly payment. They believe that in five years, they will have built a hugely successful blog and be able to afford to borrow enough to refinance the RV. They choose the balloon loan because it's the only loan they can afford. 

And this is how people get into trouble. 

Reasons to think twice before committing to a balloon loan

There are several reasons to think long and hard before taking out a loan with a balloon payment due at the end. Here are three of them:

1. An optimistic outlook doesn't always get it right

In this scenario, the couple imagines themselves together and thriving in five years. They might hope for that, but there's no way to be sure of what's around the corner. RV life could convince them that they don't like spending time together, or their blog may be a total bust. Hoping for the best is great but it does not guarantee a good outcome. 

If you're thinking about a balloon loan:

• Imagine you've taken out a balloon mortgage. Now, consider how much more difficult it would be to cover the balloon payment if you were to lose your job, or
• End a long-term relationship, or
• Run into unexpected medical bills, or
• Encounter some other bump in the road. 

2. We have no say in interest rates

Our traveling bloggers decided to take on a loan with a balloon payment because the current interest rate pushed their monthly payments out of their comfort zone. The problem is that five years later, they either need to have $200,000 in cash to repay the loan or be in the position to borrow it from another source. What if the interest rates have gone up another 3 percentage points? It is possible. In 1981, in the early days of the Carter administration, mortgage interest rates hovered around 17%. 

By going with a balloon loan, our couple bet on two things: That their business venture would be successful and that interest rates would drop. It was risky, to say the least.

If you're thinking about a balloon loan: Decide how much faith you have in your ability to predict the future of the U.S. economy and interest rates. 

3. It's challenging to budget for the future with a balloon loan looming

Ask anyone over the age of 50 what they wish they'd done earlier, and they're likely to say that they wish they'd started investing and planning for the future when they were young. Given the power of compound interest, the younger a person begins saving and investing, the earlier they can breathe easy. 

Because there's a large debt hanging over their heads, our make-believe couple can only guess what their finances will look like in five years. If they had a fixed-rate loan, they would know things like when the loan would be paid in full and the total amount they would pay in interest. That knowledge could provide a foundation for a more realistic budget. 

If you're thinking about a balloon loan: Know that having a balloon payment in your future makes budgeting trickier.

Home, auto, business, and personal loans with balloon payments are decidedly less common today than they once were, but they still exist. Like any loan, it's good to ask yourself the tough questions before signing on the dotted line.