Balloon Payments Explained
October 29, 2013
What is a balloon payment? This is a complex question, because in general, the answer requires context. In specific terms, the definition of a balloon payment can mean different things on different types of loans. For the purposes of a loan servicing system, we need one simple definition that encompasses all the others, so here goes:
A balloon payment is any amount of principal that is owed by the borrower and is projected to be left over once all scheduled payments on the loan have been made. A balloon payment can come about in any of the following ways:
Loan is amortized over a period of time, but it's due in a shorter period.
There is an override to the payment amount that lowers the payment, so the scheduled payments would be insufficient to pay the loan off by the maturity date (this is similar to #1, but comes about for a different reason).
Interest is accrued at a basis (example: ACT/360) that has a higher yield than the basis that was used to calculate the periodic payment (example 360/360).
The lack of fractional cents in our monetary system can, on its own, result in a balloon, which should not exceed one cent times the number of payments. For example, on a loan with 360 payments, if the equation for the best fit payment returned a value of 324.78398, then the payment would be $324.78 and at the end of 360 payments there would be a balance of $1.43. That payment was still the best possible fit, as a payment of either $324.77 or $324.79 would be off by more in one direction or the other.
On a simple interest loan, every time a payment is made late, interest will accrue that was not accounted for by the equation that came up with the original payment. If this is done habitually, a balloon will build up.
Whenever a loan payment rule un-bills a partial payment, that partial payment (and on a simple interest loan, the interest on that partial payment) will be inherently added to the balloon.
On a conversion loan, if the principal balance converted is too much for the loan to be paid off in the number of payments remaining, given the interest rate and the assumption that payments are made in full on their due dates, then a balloon will result.
By using an amortization schedule function that determines the amount of principal left over at the end of the loan term, a loan servicing software system is capable of using a single piece of program code for the calculation of the balloon payment, regardless of the fact that there are seven different circumstances that are potentially responsible for that extra principal.