Stop-gap arrangements are sometimes the first option chosen by individuals in need. While long term options are a prudent choice, the lack of time or the pressing nature of specific requirements may make stop-gap arrangements appear to be a right choice. This is precisely what happens in the case of loans and mortgages.
Interestingly, balloon payments that are regarded as the quick way out of a solution effectively sound solutions in certain instances. Loans and mortgages with a medium to long term tenure are often taken based on expectations of a change in the earnings.
While it is debatable to clearly label balloon payments as suitable or unsuitable in such cases, it is clear that balloon payments are a good option for individuals with a stable income generation model.
Granular look at Balloon Mortgage Payments
Here is a granular look at balloon mortgage payments. Overall, balloon payments have comparatively lesser interest rates than those of other mortgages and loans. In balloon payments, technically, amortization occurs only when you repay the entire amount at the end of the tenure.
This contrasts with other loans and mortgages where the amortization occurs alongside the monthly repayment. For instance, other loans/mortgage repayments involve two different components – the interest component and the principal component.
A borrower typically repays the interest and a part of outstanding principal as amortization. The outstanding principal gradually decreases as the amortization progresses during the tenure of the loan. There is a gradual increase in the principal component that is repaid, with a corresponding reduction in the interest during the tenure.
However, this process of working out the interest and the principal may not appear clearly at first glance to a borrower. This is because, in individual loans, the amount to be repaid monthly is a fixed cost.
This amount is calculated based on the interest rates and the decreasing outstanding principal amount. For instance, you may have inked an agreement to repay a fixed amount of 1000$ every month as part of repayment. This may remain unchanged throughout the tenure of the loan.
However, the amount that goes towards interest repayment and the amount that goes towards amortization will change month on month throughout the repayment tenure.
Balloon repayments differ from traditional loan repayments as the model involves shifting a bulk of the principal towards the end of the tenure. Effectively, this means that in a balloon repayment, the interest is the significant component throughout the repayment tenure. Typically, only 15% of the principal is repaid during the repayment, while the remaining 85% is compensated as a lump sum when the loan tenure ends. This is eh final settlement of the mortgage.
When will balloon repayments work to your advantage?
Balloon repayments will work to your advantage only when you have a stable income, which will permit you to build up a fund for repayment. To put it differently, you need to be in a position to set aside the desired amount in some form of investment or fund, which will be equal to the amount that needs to be repaid at the end of the tenure.
You could also use this option when you are in expectation of a considerable amount that could accrue to you at the same time as the end of the balloon mortgage loan. For instance, any of your investments could mature at that time, or you may expect an inheritance or a sale. If you are within sight of such a windfall or if you are in a position to build a fund, then balloon repayment models are a good choice.
However, for a large number of individuals, things do not work out as planned. Eventually, the individual ends up going in for sale or refinance to resolve the repayment. A sale is the last resort, while refinance the first choice to wriggle out of a balloon payment.
This mortgage model works best when the individual needs to reduce the interest rate and is confident of raising funds required for the repayment. Interest rates are relatively lesser when compared with other loans in addition to keeping the monthly amount payable as low as possible.
Short term tenure of a balloon mortgage
Balloon mortgage repayments are essentially short term in nature and average around seven years. As a result of the short term nature of balloon mortgage, the interest component rate is relatively lesser than that of other loans. The difference in interest rates could be anywhere from .10 % to 1%.
While this may not appear significant at a glance, it is actually sizeable, especially when the loaned amount is higher. Loans with longer tenures have higher interest rates as it exposes the lender to an extended liability. To offset the risks of an extended liability, the interest rates are higher.
Additionally, as the payable amount only involves a fraction of the principal amount, the actual monthly payout is considerably lesser. The difference could be an astonishing 40%. This difference can help the borrower to use the excess funds for other regular expenditure.
Long term payouts that involve a hefty amount month on month can limit the disposable amount available at hand. With a balloon repayment model, it is possible to easily free up the disposable amount and easily manage the repayments.
Unforeseen risks associated with balloon repayment models
Balloon repayment models have calculated risks. You can safely opt for balloon repayments, only when you are confident of handling the risks involved. Many borrowers tend to choose balloon repayments with a plan of availing a refinancing option before the end of the tenure. The idea is to take out a mortgage, pick a refinance before the end of the tenure and avail the benefits of lower interest during the mortgage and the refinance.
This works out only when the scenario plays out as planned. Things could go wrong anywhere during the tenure. For instance, the value of the property may have dipped due to unforeseen factors. Similarly, it is virtually impossible to accurately predict the interest rates seven years from the present date. It could be higher or lower prevailing rates.
Therefore, the plan to opt for refinancing to reduce interest rates may backfire at any point in time.
Other possible risks include your credit score taking a hit, somewhere down the line, making you ineligible for a refinance. Imagine the prospect of having a mortgage on your hands and a looming balloon repayment in a year? It is certainly not a good situation that one would want to find oneself in.
Deferred repayments – a good option for the right borrowing conditions
Deferred repayments in home, auto, and business loans are good choices, but only for the right borrowing conditions. Lower interest rates and lesser monthly exposure to liabilities are always welcome to all categories of borrowers. However, the actual problem emerges only when the tenure comes to an end. Therefore, balloon repayments are to be used only if you have planned out the repayment and have an action plan.
Deferred repayment models should never be used as a stop-gap arrangement as you may end up in extremely challenging situations. Make the right plans and put the ideas into action before you choose balloon repayment options.
Ask yourself a few questions before you select this mode of a mortgage.
Q1: Do you expect to receive a considerable amount before the end of the mortgage tenure? Do you have the capability to build an investment portfolio that will mature simultaneously as balloon repayment?
Q2: Do you have a fixed and consistent income-generating capacity that will guarantee savings to repay the amount?
Q3: Do you have a fallback option?
Q4: Are you confident of keeping your credit score at suitable levels to ensure refinancing eligibility at the end of the tenure?
If you have the right answers to the above questions, balloon payments will be a prudent choice for your mortgage.