Background
Loan repayment consists of two components - the principal amount and the interest amount. The principal component consists of the amount borrowed by the borrower whereas the interest component consists of the charges levied by the lender to the borrower for using his resources. The latter becomes the borrowers’ cost of borrowing funds.
The principal and interest may be paid together, or separately. Broadly, there are two types of loans distinguished on the basis of repayment, namely non-amortizing loans and amortizing loans. Non-amortizing loans can be further classified into balloon loans and bullet loans.
In this article, we analyze the concept of balloon loans and distinguish it from other types of loans.
The Concept of Balloon Loans
For loans with a balloon payment, the borrower pays a humongous amount of the loan to the lender at the end of the tenure of the debt. The borrower continues to pay the lender the amount of principal and interest during the tenure of the loans, however, the amount of payment/repayment is small and it is at the end of the tenure that a large, balance amount of principal and interest is repaid. The payment at the end of the tenure consists of both, principal and interest. It is not that the loan will not be amortized over the tenure of the loan. The loan will be amortized as the principal and interest dues keep reducing; however, the loan tenure ends before the loan amount is entirely amortized. At the end of the tenure, the balance loan is to be repaid or it may be refinanced.
In a nutshell, in the case of balloon loans, in the initial years, the loan re-payments are lower however the lump-sum payment at the end of the tenure is very high.
Areas of Concern
The repayment amount of the loan at the end of its tenure is very large. This makes the borrower liable for a huge amount of re-payment at a single point of time. Thus, situations may arise wherein the borrower is not in the financial capacity to repay the loan. In such a case, he relies on repayment of the loans by selling the underlying asset bought from the loan availed. Things are good as long as the realisable value of the underlying asset is equal or more than the amount of loan repayment. However, in case even the underlying asset fails to make up for the outstanding loan amount, the borrower defaults and the asset becomes bad for the banks. The default scenario is of a huge concern, when the defaulting loan is a balloon loan, as the loan amount due at the end of the loan tenure is large and so is the default amount.
An alternative method of repayment of balloon loans is refinancing of the loan the end of the tenure, in case the borrower is not able to re-pay the loan at the last installment. Now, this payment method provides leverage to the borrower, to pay the loan within an extended duration. However, akin to the other methods, this involves huge default risks to the lender as the borrower who does not have initial repayment capacity have a higher probability of default on their next payments, as compared to good borrowers. In fact, this core feature of balloon loans makes them an unviable financing option to most of the financing needs.
Bullet Loan vs. Balloon Loan vs. Amortising Loan
As we have read hereinabove, re-payment of balloon loan entails payment of a minor portion of principal and interest during the tenure and a huge portion of interest and principal at the end of the loan tenure. However, in case of bullet loan, only a minor portion of the interest is paid during the tenure of the loan and the entire principal as well as remaining interest is paid at the end of the tenure.
Amortising loans are structured in a manner wherein the loan re-payments are made such that a proportionate amount of principal as well as the interest is repaid at timely intervals. All the payments are equivalent, therefore there is no balance in the loan account at the end of the tenure and the loan is extinguished by the time loan tenure ends.
Bullet loans and balloon loans have a shorter tenure than amortising loans, as a huge sum of money is due at the end of the loan tenure. Similarly, the interest rates charged to these loans are higher than amortizing loans, as the borrowers have the convenience of paying the whole loan amount at a future date and accordingly, does not immediately affect the cash flows of the borrower. Further, payment structures like these entail a huge default risk to the lender. These loans also indicate increased time value of money of the lender, as the amount remains with the borrower for a longer duration as compared to the amortizing loan structure. In general parlance, bullet loans and balloon loans are used interchangeably as the nature of both categories of loans are similar.
The principal and interest payments in either of the three cases can be discussed in the following manner:
Figure 1: Figure representing the yearly outstanding principal amount in the case of bullet loans, balloon loans and amortizing loans.
In figure 1, we derive that in the case of bullet loans, the principal outstanding remains constant over the tenure of the loan, and it is only in the last year of the loan that the entire principal is re-paid. Whereas in the case of balloon loans, the principal is repaid over the tenure of the loan however the proportion of loan repaid is relatively small and the major payment is made only in the last year of the loan tenure. Whereas in the case of amortizing loans, the principal is consistently repaid over the tenure of the loan such that the value of the outstanding principal at the end of the tenure is reduced to zero.
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