What is a balloon loan?

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In a Nutshell

A balloon loan is a type of loan that includes lower monthly payments in exchange for a larger one-time payment at the end of your loan term. If you plan to finance your car purchase, you may be offered the option of a balloon loan. But beware: While a reduced monthly payment could be ideal for your budget, a balloon loan could lead you to take on more debt or become upside down on your loan down the road.
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If you’re shopping for auto financing, you may have come across balloon loans as a potential option.

This type of loan is commonly known as a balloon payment because you make a large payment at the end of the loan term. While a balloon loan can offer lower monthly payments, there are potential drawbacks worth considering before you sign on the dotted line.

Let’s take a look at how an auto balloon loan typically works and the potential pros and cons of this financing option so that you can decide if this type of loan fits your needs.

How an auto balloon loan works

Some lenders offer balloon loans as a car-financing option. This type of loan works differently from a traditional auto loan.

Balloon loans vs. traditional loans

With a traditional auto loan, you make a series of monthly payments, based on your loan amount, interest rate and loan term, to chip away at your principal balance and interest and pay down your loan over time.

With a balloon loan, you make lower monthly payments until the end of the loan term. Keep in mind that despite the reduced monthly payments, your interest rate on a balloon loan might be higher. Some lenders offer lower interest rates on traditional car loans.

And at the end of the term, you make a final payment that’s significantly larger than your previous monthly payments to pay off the loan. This lump sum is known as a balloon payment.

The amount of the balloon payment can vary. For example, it might be a percentage of the manufacturer’s suggested retail price (or MSRP) of the car you’re financing or based on the estimated value of the car at the end of the loan term.

Options at the end of a balloon loan

When this balloon payment comes due, you may have a few options, depending on the lender. Here are a few.

  • Make the balloon payment and keep the car.
  • Refinance the loan balance and retain possession of the vehicle.
  • Trade in the vehicle for a new one — depending on the lender, you may still be responsible for some or all of the balloon payment and additional costs.
  • Return the vehicle to the lender to help pay down the remaining balance on the loan and then walk away from the car. But know that if the value of the car doesn’t cover the balloon payment though, you may still be on the hook for the remaining balance.

If you choose to trade in or return your car to the lender, you might face some additional fees.

  • Disposition fee This fee covers the lender’s costs to prepare the vehicle for sale, which may include expenses such as vehicle transportation costs, cleaning and reconditioning, and administrative fees.
  • Excess mileage fee — Some lenders place a limit on the number of miles you’re allowed to drive each year.
  • Excess wear-and-tear charge — Lenders may charge for damage beyond typical wear and tear, such as broken or missing parts, cracked glass, dents or fabric stains.

Before taking on a balloon loan, be sure you understand all your options at the end of the loan term and any associated fees.

Is a balloon loan a good idea?

A balloon loan comes with both potential benefits and drawbacks.

The one main benefit is the reduced monthly loan payments. A balloon loan allows you to finance a car with monthly payments that are usually lower than the payments you’d make with a traditional auto loan.

But an auto balloon loan also comes with risks.

You could end up taking on more debt

A balloon loan comes with a big one-time payment at the end of the term. Lenders may present refinancing as an option for paying your one-time balloon payment. Refinancing would mean that rather than making the balloon payment (which would pay off your loan), you’d be taking on a new loan and paying interest on that loan over a new loan term.

And if interest rates have gone up or your financial situation has changed since you took out the balloon loan, you could end up paying a higher interest rate on your new loan than you did on the original balloon loan.

You may not qualify for refinancing

Refinancing your auto loan is sometimes presented as an option if you’re unable to make the final balloon payment. But if your credit declines during your balloon loan term, you may find that you no longer qualify to a refinance a loan. If so, your only option may be to sell or return the car to the lender to avoid defaulting on the loan.

You could quickly end up upside down on the loan

The smaller monthly payments that come with a balloon loan may not be enough to keep up with the car’s depreciation. If this is the case, you could find yourself upside down on your loan — which is when you owe more on the loan than the car is worth. Being upside down can come with some financial risks. For example, selling the car at the end of your loan term and getting enough to pay off your loan could be difficult.

Next steps

If you’ve decided that a balloon loan is your best choice, read the terms of the loan very carefully. Find out how your monthly payments and balloon payment are calculated, what your options are when your balloon payment is due, and what fees will be associated with each option.

Start planning ahead for that final balloon payment from the moment your loan term begins. If possible, put aside some money each month for the balloon payment to help make sure that you have enough cash in hand to pay off the loan and keep the car.

About the author: Warren Clarke is a writer whose work has been published by Edmunds.com and the New York Daily News. He enjoys providing readers with information that can make their lives happier and more expansive. Warren holds a Bac… Read more.