Balloon Payments Effect on Loan Interest

How does balloon payments affect interest on a loan?

1 Answer

Balloon payments on mortgage loans affect interest rates in a couple of ways, but the affect depends on which type of interest you are asking about. One way that the note rate is affected is that a loan with a balloon payment has a shorter term than a loan with a similar amortization without a balloon. A loan with a shorter term typically has a lower rate than a similar loan with a longer term. The longer a lender or investor has to commit to a particular rate the higher the rate or yield they want from that loan to hedge or protect against future increases in interest rates. So the note rate on balloon loans is typically lower than the note rate on similar loans without a balloon payment.

Interestingly enough the affect on the Annual Percentage Rate of a balloon loan, versus a similar loan at the same note rate that does not have a balloon feature, is that the APR is higher on the loan with the balloon payment. Here's why. Let's compare two loans with the same note rate of 6% and the same closing costs, or more accurately "Prepaid Finance Charges" of $2,000 with 30 year amortizations. The only difference in them being that one has a balloon payment at the end of five years. They have the same loan amount, the same closing cost, the same monthly payment, the same note rate . . . everything is the same except that one loan has a balloon payment due at the end of five years. The APR on the loan without the balloon payment is 6.189% and the APR on the loan with the balloon payment is 6.484%.

Why is this? The answer is that the finance charge used to calculate APR not only includes the interest paid monthly (the note rate interest due on the unpaid balance) it also includes some of the closing costs of acquiring the loan or "Pre-paid Finance Charge." (Note: Do not confuse "Prepaid Finance Charge" with "prepaid closing costs" which is a term commonly used to describe insurance, pre-paid interest, amounts needed to start an escrow or impound account, etc.) If you pay $2,000 in additional finance charges to borrow money for five years the annualized cost of that credit is higher than if you pay $2,000 in additional finance charges to borrow money for 30 years, all other factors being equal. So if a loan has "Pre-paid Finance Charges," and most loans do, a loan with a balloon payment will have a higher APR than a similar loan at the same note rate without a balloon payment.