If your business needs cash fast and on manageable payment terms, one option is a balloon loan. These short-term loans let you pay the interest during the loan term and then you make a final "balloon" payment at maturity to pay off the balance of the principal. Balloon structures can be adapted for any type of commercial loan, but they're typically used for mortgages and large asset purchases.
TL;DR (Too Long; Didn't Read)
A balloon payment is a onetime payment at the end of the loan term that pays off the remaining balance. It's called a "balloon" because the amount is very large compared to the previous monthly payments.
Balloon Payment Explained
Balloon loans have short terms of around five to seven years. To keep payments manageable over such a short payment period, the monthly payment is based on a 30-year repayment plan, and the remaining balance is due as a lump sum at the end of the term. The final payment is called a "balloon" payment because the amount is very large in comparison to the monthly payments you have made before. Balloon loans are attractive to new businesses that don't have much of a credit history since they are typically easier than conventional loans to qualify for.
How a Balloon Payment Works
Most balloon loans are interest-only loans. Unlike with a traditional loan where you're repaying some of the principal amount you borrowed every month, with a balloon loan you pay only the interest that has accrued on the loan, or the interest plus a very small amount of principal. This results in a smaller monthly payment, but at the end of the loan, the other shoe drops, and you have to pay back the entire principal in one giant payment.
Options at Loan End
Balloon payments tend to be at least double the amount of the previous monthly payments and can run to many tens of thousands of dollars depending on the amount borrowed. Since that's not easy to pay off in one bite, most businesses look for other options when the loan term is up. Usually, that involves selling whatever asset you bought with the loan or refinancing to a conventional loan. To pull this off, you'll need to pass the bank's credit checks and show a history of timely payments. If you can't get approval to refinance, then you have to pay off the balloon payment in full.
Calculating a Balloon Payment
The lender calculates the balloon payment using a loan balance formula, which essentially is the same formula used to calculate the remaining balance on a conventional loan. Suppose you borrow $100,000 over 15 years with a 6 percent interest rate, compounded monthly. With a conventional loan, you'd pay back $843.86 per month. Plug that payment into a "5/15" balloon formula – a five-year loan that's amortized over 15 years; after 60 payments, the remaining balloon payment would be $76,008.88. You can use an online calendar to track your final balloon payment and amortization schedule.
Jayne Thompson earned an LL.B. in Law and Business Administration from the University of Birmingham and an LL.M. in International Law from the University of East London. She practiced in various “Big Law” firms before launching a career as a business writer. Her articles have appeared on numerous business sites including Typefinder, Women in Business, Startwire and Indeed.com.