3 reasons to think twice before committing to a loan with a lump sum payment

With today’s low interest rates, a balloon loan rarely makes sense.

Key points

• Loans with a lump sum payment usually pay little or nothing on the principal of the loan.
• A balloon loan can make it easier to borrow the money you need, but it can also make it harder to budget for the future.

Recently, I read about people (and organizations) taking out loans with lump sum payments, and frankly, I felt like I was back in the late 1980s. a lump sum loan won’t save you money in the long run, it rarely makes sense. Here’s why.

How does a balloon loan work?

Let’s say you need a loan for a house, land, RV, or some other major expense. The average interest rate is 12.50%, but the lender offers you a balloon loan. If you accept the offer, your interest rate will be lower (perhaps much lower) and your monthly payment will be more manageable. You will make the lower payment for a number of years, usually around five.

However, your monthly payments may not repay the principal of the loan, depending on the structure of the loan. For instance:

• Some balloon loans are unamortized, which means you only pay interest and nothing is applied to the principal. If you borrowed $200,000, you still owe the full $200,000 when the balloon matures. In addition, you no longer have any fees that you paid.
• Some are structured so that a small portion of your monthly payment goes toward principal, but the bulk still covers interest.

Why do people opt for balloon loans?

Imagine that a couple buys a deceived motorhome and plans to travel the country and blog about their experience. To buy the RV, they need to borrow $200,000. They are offered a loan with an APR of 11%.

The couple agree they can’t afford the 11% monthly payment, so they’re considering a 5-year balloon loan with a much lower interest rate and monthly payment. They believe that in five years they will have built a hugely successful blog and can afford to borrow enough to refinance the RV. They choose the balloon loan because it is the only loan they can afford.

And that’s how people get in trouble.

Reasons to think twice before committing to a balloon loan

There are several reasons to think long and hard before taking out a loan with a lump sum payment due at the end. Here are three:

1. An optimistic view is not always enough

In this scenario, the couple imagine themselves together and thriving in five years. They might be hoping for that, but there’s no way to be sure what’s in store for them. The RV life might convince them that they don’t like spending time together, or their blog might be a complete failure. Hoping for the best is good, but it does not guarantee a good result.

If you are considering a balloon loan:

• Imagine that you have taken out a balloon mortgage. Now consider how much harder it would be to cover the lump sum payment if you were to lose your job, or
• Ending a long-term relationship, or
• Face unexpected medical bills, or
• Meet another bump in the road.

2. We have no say in interest rates

Our travel bloggers decided to take out a loan with a lump sum payment because the current interest rate pushed their monthly payments out of their comfort zone. The problem is that five years later they must either have $200,000 in cash to pay off the loan or be able to borrow it from another source. What happens if interest rates have risen another 3 percentage points? It’s possible. In 1981, at the start of the Carter administration, mortgage interest rates hovered around 17%.

By opting for a balloon loan, our couple bet on two things: that their business will be successful and that interest rates will fall. It was risky, to say the least.

If you are considering a balloon loan: Decide how confident you are in your ability to predict the future of the US economy and interest rates.

3. It’s hard to budget for the future with a looming balloon loan

Ask anyone over 50 what they wish they had done earlier, and they’ll likely say they wish they’d started investing and planning for their future when they were young. Given the power of compound interest, the younger a person starts saving and investing, the sooner they can breathe easy.

Because they have a lot of debt hanging over their heads, our fictional couple can only guess at what their finances will look like five years from now. If they had a fixed rate loan, they would know, for example, when the loan would be repaid in full and the total amount they would pay in interest. This knowledge could serve as the basis for a more realistic budget.

If you are considering a balloon loan: Be aware that having a lump sum payment in your future makes budgeting trickier.

Home, auto, business and personal loans with lump sum payments are significantly less common today than they once were, but they still exist. Like any loan, it’s good to ask yourself the hard questions before signing on the dotted line.