Balloon Loans

by Michael Shohoney March 2, 2009 10:09

A question that we often deal with is how to structure balloon loans.  In a future post, we will look at how to mechanically structure balloons using eZMath and ZMath.  In this post we are going to discuss the different types of balloon loans and how they are structured.

 The first type of balloon loan is the type where a customer would like to pay a certain amount per month and the balance remaining on the loan with the final payment.  In order to have a balloon (i.e. a balance remaining at term), the desired payment must be less than the regular payment amount that would be calculated given the other terms (i.e. interest rate, term and amount) of the loan.  At the same time, it is usually essential that the payment amount desired by the borrower be enough that amortization (i.e. balance reduction) is occurring.  If those two criteria are met and a lender's policy will allow balloon lending, then the loan can be structured in this way.

 The second type of balloon loan is the type where the customer would like a certain amount of the loan to be left remaining (i.e. unamortized) at term.  That remaining balance will be paid with the final payment.  What occurs with this type of loan is that once the final balance is determined or set by the borrower, the regular payment amount is calculated.  That payment amount is made for one less than the number of payments in the loan and the final payment is the balance remaining plus the regular payment amount.  These types of balloons are often used when the borrower is expecting some kind of cash flow that coincides with the final payment of the loan (i.e. sale of the collateral, etc.) and the balance remaining equals or is slightly less than that cash flow.

 The final type of balloon loan is the type where the term upon which the payment amount is calculated (the amortization term) is less than the actual term of the loan.  We call this a prepay balloon.  This is the type of balloon loan that we commonly see in mortgage lending.  Sometimes it is termed a "X/Y Balloon Loan" where X is the amortization term and Y is the actual term (i.e. 30/7 Balloon Loan).  In this type of balloon, the payment amount is calculated based on the amortization term.  That payment amount is made for the number of payments in the actual term.  The resulting balance at term is paid in full (or refinanced) with the final payment.

That summarizes the types of balloon loans seen in the lending industry.  Our loan calculation software packages, eZMath and ZMath, easily calculate all three types.  In a posting in the Calculators 101 section in the next few days, we will look at how to structure each type.  In the mean time, if you ever have any questions on subject matter or the mechanics of running our software, please feel free to contact us.