Balloon payment

What it means

A balloon payment is the final instalment of a loan or lease that is much larger than all the previous ones. It arises when only part of the principal is repaid during the term and the rest, often 20 to 40 % of the original amount, is pushed to the end. The name describes the chart: a flat line of instalments with a balloon at the end.

The advantage is lower monthly payments that fit the company’s cash flow better, especially for a new machine or vehicle not yet earning at full capacity. The drawback is that interest is paid on a higher balance for longer, so the total cost is higher, and a large sum is needed at once at the end.

In operating car leases a similar principle hides in the residual value: the client pays only for the car’s loss of value during the contract and then returns it or buys it for an agreed sum. With loans, a balloon is often combined with a plan to refinance it at the end with a new loan.

How it works in practice

In the accounts a balloon payment is booked like any other principal repayment, but it changes the split of the liability between current and non-current. In the year before maturity the whole balloon moves to current liabilities, which suddenly worsens liquidity ratios and may affect covenants in other loan agreements.

Under a finance lease of an asset the company depreciates, the balloon payment feeds into the acquisition cost and depreciation just like the other instalments. Under an operating lease or rental it usually becomes a cost only when the asset is bought out. We always assess the exact treatment from the contract.

We advise companies to enter the balloon payment in the repayment schedule and the long-term financial plan and to start arranging refinancing at least a year ahead. When refinancing, banks look at the company’s current results, and if they have deteriorated a new loan may not be available.

What to watch out for

The biggest risk is assuming refinancing will be a formality. If interest rates rise, the collateral loses value or business goes badly in the year of maturity, the bank may refuse a new loan and the company is left with a debt it cannot repay in one go.

The second mistake is comparing offers only by the monthly instalment. An offer with a balloon almost always looks cheaper, even though the total cost including interest and fees is higher. Compare the APRC or the total amount paid over the whole term instead.