Definition: The Balloon payment is the final amount paid against the loan and is much higher than the regular monthly installments. Simply, the lump sum amount attached to a loan which has to be paid (generally at the end of the loan period) to extinguish the loan is called as a balloon payment.
The need for a balloon payment may arise due to the inadequacy of the previous installments in setting off the loan amount or due to some error or late payments. If any loan comes with a balloon payment, it is termed as a “Balloon Loan”.
Such payment is more prevalent in the mortgage cases, where the full amount is not amortized over a period of time, and the final payment is due at maturity. Thus, the final payment is called the balloon payment because of its larger size (value).
The Balloon loans may be useful for those investors whose monthly cash flows are uncertain and believes that will be able to pay off the lump sum amount at the time of maturity. But, this kind of loan carries a huge risk, as there could be a situation when an investor may not be able to pay such a big amount.
Therefore, to overcome such problem several lenders allow the investors to convert their balloon loans into the traditional loans, generally on or near the date when the lump sum payment is due.