A balloon payment is a large one-time payment due at the termination of a balloon-type loan. Making sure you can handle the payoff of a balloon payment on a loan is an important financial planning priority. If you have the resources to make a full or partial early payment on the balloon amount, you have the advantage of choosing from several different options. The best choice depends on your financial goals and your other savings or investment options.
Balloon Payment Loans
A loan with a balloon payment requires monthly payments for a set period and then the balance of the loan — the balloon payment — must be paid in full. Balloon loans allow the purchase of a property or other use of the loan proceeds with a lower monthly payment than with a fully amortizing loan. The loan contract or agreement states the amount of the balloon payment and the date on which it is due.
Loan Rate Versus Earnings Rate
One of the major factors that determine whether it is better to pay off the balloon early is the interest rate on the loan compared to the interest you could earn from investing the money until the balloon is due. If you can earn a higher rate than the rate on the loan, it is better to invest the money and wait until the balloon is due. If the loan has a higher interest rate, you save money by paying off the balloon early. Remember that an early payoff requires you to pay the balloon amount plus any principal reduction that would be included in the payments yet to be paid.
Loan Restrictions or Penalties
Check the loan agreement for any restrictions concerning early payoff of the loan and final balloon payment. Paying the balloon off early eliminates the interest the lender would have earned if you kept making the payments. The loan agreement may include penalty payments if the balloon is paid off early. Compare the penalty amounts to any interest savings you would realize from paying the loan off early. If the penalties are too high, the better course is to save the money until the balloon payment is due.
If the balloon loan is the mortgage on a real estate property, the interest paid may be tax-deductible, reducing the benefit of paying the loan off before the balloon is due. The tax deduction reduces the effective interest rate of the loan. Treasury bonds are a great example of this. If the balloon payment on a Treasury bond is $50,000 in five years and a zero coupon Treasury costs $45,000, you could earn the $5,000 difference by investing in the bond rather than pay off the balloon now.