Balloon Loans Explained

Published by
Lethabo Ntsoane

Balloon loans are popular with motor vehicle loans and they offer a way to finance an asset with low installments. These loans are mainly issued by major banks. Balloon loans are expected to be paid up within a shorter period than the average period of a standard loan. For example, a balloon loan on motor vehicles will have a 48 months repayment period instead of a 72 months repayment period. 

What is a Balloon Loan?

A balloon loan is one that is not fully repaid over the term of the loan. It requires a specified payment at the end of the loan period to repay the remaining principal balance of the loan, rather than paying the full amount over the loan period.

Balloon loans are meant to last for a shorter term and come with a repayment duration that is shorter than that of a standard loan. Many people like the loan because it has lower monthly payments than a standard loan since a portion will be paid in a single lump sum at the end of the loan period. 

Characteristics of a Balloon Loan

  • They have a shorter payment term than standard loans.
  • Loans incur slightly higher interest payments during the loan period when compared to standard loans.
  • The loan requires a lump sum payment at the end of the loan period.
  • At the end of the loan period, banks or lenders give options to finance balloon payments.

How a Balloon Loan Works

A balloon loan is divided into two parts: monthly installments and a balloon payment. When you take out a balloon loan, you will be required to pay loan installments as well as a lump sum payment at the end of the loan period known as the balloon payment. This payment is a lump sum payment agreed upon by the lender and the borrower at the start of the loan term.

For example, you can take a balloon loan to buy a R500,000.00 vehicle paying R10,000.00 per month with 6.69% interest compounded monthly for 48 months. The balloon loan will require that you make an R114,310.00 balloon payment at amortization. Therefore, the total amount that will be paid on amortization is R584,310.00.

The difference between a traditional loan and a balloon loan is that a traditional loan will require a monthly installment of around R12,120.00 with no additional payment at the end of the loan period. However, a balloon loan will require low installments payments as there is a balloon payment due at the end of the loan period to cover the installments deficit. 

The interest rate on a balloon loan is higher than on a traditional loan. The balloon payment on the loan incurs interest over the course of 48 months, which the standard loan does not. As a result, the standard loan will incur interest of R81,760.00, whereas the balloon loan will incur interest of R84,310.00 for a 48-month loan at a 6.69 percent interest rate on an R500,000.00 vehicle.

What are Balloon loans used for?

Balloon loans can be used for business and personal financing purposes. These are the use of balloon loans. 

Vehicle Financing

Balloon loans are most commonly used in South Africa to finance a vehicle. Balloon loans require a balloon payment of up to 35% at the conclusion of the loan term. Normally, these loans are repaid in 48 months.

Building and vacant land financing

Building loans and land loans can be converted into balloon loans upon request. These loans will normally allow you to pay reduced installments and pay a lump sum at the end of the loan period. 

Home loans

Balloon loans are useful when buying a home. Home loans take forever to pay off, however, with a balloon loan you won’t have to pay off your home loan in a 20 – 30 year period. Instead, you will repay your home loan earlier but this will be subject to your income. 

Business loans

Businesses have projects that run for years and in some cases decades, therefore, lenders understand that giving businesses balloon loans is crucial. Balloon loans help businesses meet their short-term obligations, in turn, businesses are able to accelerate loan repayments on loans over time when projects become successful. 

Advantages of Balloon Loans

  • Monthly repayment on loans are lower than that of traditional amortised loans. This is attributed to the low principal being paid instead of the whole loan amount during the stipulated period.
  • Balloon loans are available for different uses and for juristic or natural persons.
  • Amortization of the loan is shorter than traditional amortised loans.
  • Borrowers can refinance balloon payment due at the end of the loan term.

Disadvantages of Balloon Loans

  • Borrowers need to pay a high percentage of the loan amount at the end of the loan term. Those with low credit scores will have difficulties refinancing their balloon payment.
  • The interest rate on the loan is high.
  • The trade-in value of the asset can be lower than the balloon payment required, therefore, a cash injection from the borrower to cover the outstanding balloon payment amount will be required.

Conclusion

Balloon loans are a great option to acquire assets that are of high value. The borrower of a balloon loan doesn’t risk being over-indebted during the loan period. The loan is beneficial to those that are expecting money in the near future from an investment or from trust fund interest allotments. Money expected for the aforementioned investment vehicles can be easily used to cover the balloon payment due at the end of the balloon loan’s term.

Lethabo Ntsoane

Lethabo Ntsoane holds a Bachelors Degree in Accounting from the University of South Africa. He is a Financial Product commentator at Rateweb. He is an expect financial product analyst with years of experience in reviewing products and offering commentary. Lethabo majors in financial news, reviews and financial tips. He can be contacted at lethabo@rateweb.co.za

Published by
Lethabo Ntsoane