Dubai: If you are looking for more flexibility and ease in paying your loans in monthly installments, especially when it comes to paying the first few months, a “balloon loan” is one such choice. But how risky are they? Let’s find out more before you decide to use them.
A balloon loan is a type of loan that involves lower monthly payments in exchange for a larger lump sum payment at the end of your loan term. It works just like a regular car loan, except that a larger mandatory “balloon” payment is deferred until the end of the agreement.
Here is an example of balloon loans
For example, if you have a balloon payment mortgage, your payments may be lower in the years before the balloon payment is due, but you could owe a large amount at the end of the loan.
Let’s say a person takes out a Dh200,000 mortgage with a seven-year term and an interest rate of 4.5 percent. Your monthly payment for seven years is Dh1,013. At the end of the seven-year term, they owe a balloon payment of Dh175,066.
What is a key benefit or risk in taking out such loans?
“Balloon loans often give borrowers access to a low interest rate. But the disadvantages often outweigh the advantages as there is no guarantee that the borrower will be able to refinance at the same lower interest rate – or even refinance the loan at all,” said Bryden Wood, a Dubai-based banking analyst.
“There are also downsides to balloon payments to be aware of: Unsecured balloon payment loans tend to have a higher interest rate than traditional loans. Paying that large balloon payment at the end of the loan can be financially challenging for your business,” Wood continued.
Is there a downside to taking out a balloon mortgage?
With a balloon mortgage, the term is usually rather short, ranging from 5 to 7 years, but the payout is based on a 30 year term. They often have a lower interest rate and can be easier to qualify for than a traditional 30-year fixed-rate mortgage. However, there is a risk to consider.
“If your property goes down in value, you lose your job, or you find yourself in some other financial hardship, you may not be able to sell or refinance before the balloon payment is due. If you can’t make the payment, you risk losing your home to foreclosure,” Wood added.
Is a balloon payment cap allowed?
“Although balloon payments are only about paying off a significant portion of your loan at the end, they are usually capped,” explains Rupesh Naish, a Dubai-based debt advisor.
“In general, most lenders limit balloon payments to 50 percent of the total amount payable. So if you want to buy a car for Dh30,000, your balloon payment must not be higher than Dh15,000.”
Are there other alternatives to balloon loans?
There is another similar option that requires less commitment from you than a balloon payment – a residual value loan. But what is the difference between residual value and balloon payment?
Simply put, a salvage value and a balloon payment are the same thing. Both refer to a pre-arranged payment that is due at the end of a loan for a vehicle, machine, or property. If the loan facility was a finance lease, the amount at the end of the lease is called the balance.
What is a residual value loan?
A residual value loan, which typically applies to car loans, applies the same principles as a balloon payment, but works slightly differently. For example, the idea is that you lease a car for a period of time and pay a flat rate at the end of the term if you want to own the car.
You continue to pay a monthly amount throughout your lease, just like a balloon payment. but you don’t commit to buying the car in the end. If you wish, you can return the car to the vehicle financier or take out a new lease and continue leasing it for another specified period.
Are residual value loans better for new or used cars?
“Using residual value loans, buyers can get lower premiums for new cars, but used cars could have higher monthly premiums because their value typically depreciates more,” added Naish.
“The loan provider may monitor the number of kilometers you drive the new car and could penalize you for high mileage or lack of maintenance. After all, the mileage and condition of a car affect its resale value.”
Conclusion: Is a balloon payment a good idea?
A balloon payment can be beneficial for buyers who can save the amount they need, and for investors it can free up capital in the short term. In most cases, however, balloon repayments are an easy way to get yourself into debt.
Most average earners who cannot afford the initial repayment amount also cannot save the amount needed to pay the principal at the end of their repayment period.
“It’s not always easy to think about the long-term implications of balloon payments. Many people know how easy it is to go over budget when they’ve committed to a particular car or property, especially when a balloon payment option looks so appealing,” said Andrea Barber, an Abu Dhabi-based financial planner.
“Unfortunately, people in this position often cannot pay the lump sum at the end of the financing period and debt problems arise. As a safeguard against this, finance companies often require proof that buyers can afford a future balloon payment.”