What is a balloon payment?

A balloon payment refers to a final loan payment that is significantly larger than the previous regular monthly payments made throughout the life of the loan. This structure often arises in loans that have an amortization schedule different from the term of the loan. For example, if a buyer has an amortized payment over 30 years but the loan is due in 5 years, the borrower will make smaller monthly payments for those 5 years, and then a large "balloon" payment at the end to pay off the remaining balance.

This payment structure can be beneficial for borrowers who expect to sell the property or refinance before the balloon payment is due. However, it also entails risk if the borrower is unable to secure financing to cover the balloon payment when it comes due. The choice regarding a small payment made at the beginning of a loan does not capture the essence of what a balloon payment represents, nor do the other choices that illustrate different payment structures or amounts. Understanding the implications and timing of balloon payments is crucial for borrowers to manage their financing effectively.