Balloon payment

Key Takeaways

• A balloon payment is one oversized payment that clears the whole remaining balance when a loan matures.
• Partial amortization is what creates a balloon payment. The scheduled payments retire only part of the principal, so the rest falls due in a single lump.
• Washington requires the residential mortgage disclosure summary to state whether the loan contains a balloon payment (RCW 19.144.020).
• Seller-financed real estate contracts often end in a balloon payment. If the buyer cannot pay it, chapter 61.30 RCW gives the seller forfeiture or foreclosure.

What It Means

A balloon payment is a single, oversized payment that clears the entire remaining balance of a loan on its maturity date. It appears whenever the payment schedule was never sized to retire the debt over the loan term. A fully amortized loan splits every payment between interest and principal so that the final scheduled payment leaves a zero balance. A partially amortized loan uses smaller payments that chip away at only part of the principal, so most of the debt is still standing when the Term Of The Loan runs out, and all of it comes due at once.

Borrowers accept that trade because the monthly payment is lower than a full payoff schedule would require. The risk is that the balloon still has to be paid, and there are only three ways to do it: sell the property, refinance, or write a very large check. If values fall or credit tightens in the meantime, refinancing may not be there. A balloon payment is not the same thing as Negative Amortization, where the balance climbs above the original loan because the payment does not even cover the interest due.

How It Works in Washington

Washington regulates balloon payments through disclosure, not a ban. RCW 19.144.020 says a residential mortgage loan may not be made unless the borrower first gets a disclosure summary of all material terms. It must arrive within three business days after the lender receives the loan application, on a separate sheet of paper. The Department of Financial Institutions sets what goes on that sheet, and one required item is whether the loan contains a balloon payment. Other items include the interest rate, the broker's fees, and whether the loan carries a Prepayment Penalty.

Seller financing is where Washington brokers meet balloons most often. RCW 61.30.010 defines a real estate contract as a written agreement for the sale of real property in which the seller keeps legal title as security for the price. Payments on those contracts are often not sized to reach zero, so a balloon closes them out. If the buyer cannot produce it, RCW 61.30.020 gives the seller two paths. The seller can forfeit the buyer's rights by giving and recording the notices that chapter requires. Or the seller can foreclose the contract the way a mortgage is foreclosed in this state.

Example

Priya sells her Yakima rental to Dev on a seller-financed real estate contract for $310,000. Dev pays $31,000 down, which is 10 percent, and signs for the remaining $279,000 at 7 percent. The payment is calculated on a 30-year schedule, but the contract matures in five years.

The 30-year schedule keeps Dev's payment at about $1,856 a month, which his budget can carry. Because those payments are sized for a 30-year payoff and the contract ends at year five, only about $16,400 of principal is retired along the way. On the maturity date Dev owes roughly $262,600 in one payment. That is the balloon. Dev lines up a credit union refinance three months out, the new lender pays Priya in full, and Priya delivers the deed. Had rates or Dev's income moved the wrong way, Priya's remedy under chapter 61.30 RCW would have been forfeiture or foreclosure of the contract, not a friendly extension.

Common Mistakes and Exam Traps

• A balloon payment does not mean the loan was interest only. Interest-only loans always end in a balloon, but a partially amortized loan that pays down some principal leaves one too.
• A balloon payment is not negative amortization. The balloon leaves a large balance unpaid at maturity, while negative amortization makes the balance grow past the original loan amount.
• A balloon payment is not a prepayment penalty. The balloon is the lump the contract requires at the end, and a prepayment penalty is a fee charged for paying off early.
• Federal qualified mortgage standards bar a loan that results in a balloon payment except in narrow cases (12 CFR 1026.43), so calling a balloon-payment loan a standard qualified mortgage is wrong.