I work in finance at a large company. We get leases and loans for large purchases, just like a consumer. When we sign a new lease or loan contract, they often have balloon payments, just like consumers. Part of my job is to determine whether it is a better deal for the company to lease or buy new equipment, and balloon payments are always favorable compared to loans without balloons, and they almost always are to consumers to, despite everything bad you may have heard about them.
First, it is important that everyone knows what a balloon payment is and how balloons work. A balloon payment is a deferred amount that is paid in lump at the end of a loan/lease. For my company, those lumps can be as high as $3,000,000 or more depending on the size of the equipment. For consumers, the balloon is usually in the thousands of dollars range.
Why Balloons Are Good: The time value of money demonstrates that deferring payments is beneficial because you can earn interest on the money rather than give it to someone else to earn interest with. If the loan interest rate is 4.95% and you can earn 5% or more in another investment, you are better off deferring the payment. In the corporate world, if the interest rate is lower than the discount rate, or cost of capital, the loan with deferred payments is favorable.
Why Balloons Are Bad For Some People: A 15% balloon on a $100,000 mortgage leads to a $15,000 payment at the end of the life of the loan. If you are smart, you would stash away $42 per month in a high interest savings account (affiliate link) over 30 years to cover the balloon at the end. Everyone is not that smart.
Some people spend that $42 every month and have no way to pay off the loan at the end. This is poor planning, and is not the bank’s fault. It is the fault of the person who signed papers for a loan they could not handle.
How To Make Balloons Work For You: If you can’t earn more in interest than your loan interest rate, it is in your best interest to pre-pay everything as fast as you can. If you can do better elsewhere, such as the stock market or bond investments, it is best to delay payments as long as possible. Just be sure to save every month so you can pay it at the end.
Ever had a baloon loan or know someone with a good story? Please share in the comments.