Promissory notes with balloon payments are a financing option you may be considering for your business. These types of loans may be secured by collateral or not, but they always end their repayment schedule with a big payment, known as the balloon payment. Reviewing the pros and cons of this scheme can help you make a decision about what may be best for your business.
Understanding promissory notes
A promissory note is a loan agreement between a lender and a borrower. The lender provides money to the borrower, who promises to pay it back.
Some promissory notes are secured, which means that collateral is placed against the loan (for example, a car loan has the car as collateral). With a secured note, a piece of property serves as security for the loan—your business could use a piece of equipment as collateral. If the borrower does not pay the loan back, the lender can take possession of the property.
Promissory notes can also be unsecured, which means there is no collateral backing the loan.
How balloon payments work
Conventional loans are set up so that the borrower makes regular payments throughout the life of the loan, made up of interest and principal (amortized to create equal payments). When the final payment is made, the entire loan is paid off.
When a loan has a balloon payment, it means that the regular payments are generally made up of interest only—which makes the payments smaller—and the very last balloon payment on the loan is the entire principal of the loan.
Pros of balloon payments
Balloon payment promissory notes do have some advantages to consider:
- The regular loan payments (up to that big balloon payment) are smaller, since they are interest only. This can allow a small business time to build up its profitability before having to pay back the principal.
- A balloon payment loan can be a good alternative if your business lacks credit. The loan may give you additional time to build up your credit.
Cons of balloon payments
There also are drawbacks to balloon payment promissory notes that should be considered:
- Unsecured loans with balloon payments usually have a higher interest rate than conventional loans.
- Paying that large balloon payment at the end of the loan may be financially difficult for your business.
- If the balloon payment loan has collateral and your business is unable to make the final payment, you will lose the collateral.
Final payments on balloon loans
When your business makes the balloon payment on your loan, it is the final payment and the loan will be completely satisfied. The lender should give you a final payment letter or final payment release form, showing that the loan has been paid.
Creating promissory note balloon payment loans
Promissory notes with balloon payments can be a good source of funding for your business if you carefully weigh the pros and cons. Be sure to consider a variety of options before choosing funding for your venture.
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FAQs
Balloon payments are an option for home mortgages, auto loans, and business loans. Borrowers have lower initial monthly payments under a balloon loan. The interest rate is usually higher for a balloon loan, and only borrowers with high creditworthiness are considered.
What is the major problem with balloon payments? ›
The most significant risk of a balloon mortgage is foreclosure if the borrower can't make the balloon payment at the end of the term. Foreclosure can result in the loss of the home, emotional distress, and impact the borrower's credit negatively, generally for seven years.
What are the risks of a balloon payment? ›
What are 4 things borrowers need to know about balloon loan payments?
- Lenders might not refinance your balloon loan. ...
- Balloon loans are riskier for commercial real estate investment. ...
- The price of the loan might be higher in the long run. ...
- The burden at the end can be great.
Once the balloon is paid, you'll owe nothing more on the car and can keep it for as long as you like. It's also a good option if your car is worth more than its guaranteed minimum future value.
What is the disadvantage of a balloon? ›
Disadvantage 3: Limited Lifespan
Balloons have a limited lifespan. Over time, they deflate, and the once festive atmosphere can turn lacklustre. Something to consider for events that span more than a day.
Who benefits from a balloon payment? ›
Balloon loans can offer flexibility in the initial loan period by providing a low payment. Still, borrowers should have a plan to pay the remaining balance or refinance before the payment comes due. These loans do have their place—for those who only need to borrow for a short time, they can offer significant savings.
What if I can't afford the balloon payment? ›
If you're unable to pay the amount in full by the end of your finance term, you can opt for refinancing. This is simply a matter of taking out another loan with new terms and interest rates to pay the balloon amount. With the balloon payment settled, you'll make monthly payments for your new loan.
How to avoid paying balloon payments? ›
How to Avoid Balloon Payment?
- Pay in Full: Settle the Balloon Payment. ...
- Refinancing Options: Managing Balloon Payments. ...
- Trade-In Route: Alternatives for Balloon Payments. ...
- Make Extra Payments: Gradually Reduce the Balloon Amount. ...
- Negotiate with the Lender: Seek Flexible Repayment Terms.
You will end up in foreclosure for inability to pay that last balloon payment. Sometimes, you can refinance your home before the balloon hits, to pay it off, and stay current on your loan. But you may have no idea if, when that time comes, you will have the credit or the equity in the property to do that.
Why is it best to avoid a loan that involves a balloon payment? ›
By avoiding a balloon payment, you can make smaller monthly payments through the life of the loan, which can help you manage your finances more effectively. Additionally, avoiding a balloon payment can help you avoid any surprises when it comes to your loan payments.
Instead of paying off the full loan amount gradually through regular repayments, a chunk of it is deferred until the end of the loan term. This portion of the loan becomes the balloon payment. It's generally between 20-40% of your loan amount depending on what you agree with the lender.
What is a normal balloon payment? ›
A balloon payment is a one-time, larger-than-usual payment made at the end of a loan term. Balloon loans are an alternative to traditional loans for things like homes, cars and businesses. Balloon loans typically have lower monthly payments than traditional loans. But they may come with higher interest rates.
What is the disadvantage of a balloon mortgage? ›
Another huge disadvantage is since you're primarily paying interest with your monthly payments, you're not accumulating any equity in your home. Another consideration is that some balloon loans come with a “reset” option at the end of the set term.
What are the advantages and disadvantages of balloon dilation? ›
The theoretical advantage of this approach is the preservation of the sphincter function. The drawback of balloon dilation is a more limited size of the papillary opening, which may limit the size of the stone that can be extracted using the balloon or a basket catheter.
What is a major disadvantage of balloon loan financing is that the borrower? ›
But the disadvantages often outweigh the positives, as there is no guarantee that the borrower will be able to refinance at that same lower rate—or will be able to refinance the loan at all. As a result, the borrower may have no choice but to default on the loan.
How to avoid balloon payment on car? ›
How to Avoid Balloon Payment?
- Pay in Full: Settle the Balloon Payment. ...
- Refinancing Options: Managing Balloon Payments. ...
- Trade-In Route: Alternatives for Balloon Payments. ...
- Make Extra Payments: Gradually Reduce the Balloon Amount. ...
- Negotiate with the Lender: Seek Flexible Repayment Terms.
