Balloon Loan - Everything You Need to Know
As we've written before, we can't always control the timing of taking out a mortgage. We might enter a deal that requires transferring money before the funds are actually in hand. Before we panic and go hat in hand — borrowing from our parents or cashing in study funds — we may already have assets that let us raise the money we need more cheaply.
Balloon loans and grace-period loans answer our needs during these transitional periods. While a grace-period loan is suited to a situation in which we have a temporary cash-flow difficulty, a balloon loan is designed to deal with a temporary capital shortfall.
In this article we'll explain what a balloon loan is, the restrictions on taking one out, how the bank prices it, and how best to fit it into the mortgage mixture.
What is a balloon loan and why would we use one?
- Phase A: interest-only payments
- Phase B: repayment of the full principal — in a single lump sum.
A balloon loan (also called a bullet loan or bridge loan) is a short-term loan (usually up to 36 months, though some banks allow exceptions) that lets us transfer capital to the seller now, based on funds we expect to receive in the near future. The payment structure is monthly payments covering interest only, and at the end of the term the entire principal is repaid in a single lump sum.
There are loans in which the interest is also not paid during Phase A. Such a loan is called a full balloon, and it is uncommon because the debt to the bank balloons through compound interest (this represents a major risk for the borrower).
Suppose we borrowed 1,000,000 NIS in a balloon loan at an annual interest rate of 3% for a term of 12 months. In that case, the monthly interest rate is 0.25% of the outstanding principal (we divided the annual rate by 12 months). The monthly payment is therefore 2,500 NIS (the monthly interest rate multiplied by the principal amount).
Because we make no payment toward the principal, the outstanding balance the following month is still 1,000,000 NIS, so the next payment is again 2,500 NIS — and so on throughout the life of the loan. At the end of the term, after 12 months, we repay the entire remaining debt — 1,000,000 NIS.
Note that in a CPI-linked balloon loan the principal can grow (due to CPI indexation), and as a result the monthly payment will increase.
The most common reason a bridge loan is needed is that we've bought a new property but haven't yet sold the one we own and/or received the full proceeds from its sale. Under the terms of the purchase, we'll need to hand the seller money that isn't yet in our possession. So we take a bridge loan against the existing property (and possibly against the purchased one too, as we'll describe below) and pay it off as soon as the existing home sells.
Conditions for obtaining a balloon loan
A balloon loan is a full mortgage loan in every sense — a loan backed by a property that serves as collateral. In other words, to get the funds we have to pledge a property to the bank, and we can't get the loan if we have nothing to pledge.
On the other hand, there are also differences between this loan and a standard mortgage. Some of the restrictions that the Bank of Israel imposes on a regular mortgage (detailed in Directive 329 - Restrictions on Granting Housing Loans) don't apply to a balloon loan. For example, the entire loan can be taken at a variable interest rate.
Another significant difference between the two loans is their effect on the payment-to-income ratio (PTI) (defined in Appendix A of Directive 329 - Restrictions on Granting Housing Loans).
The Bank of Israel caps the monthly payment on housing loans (mortgage and balloon) at 40% of our disposable income. In a standard mortgage, the monthly payment is higher (because we pay interest and pay down the principal). In a bridge loan, since we pay only interest, the payment is lower. So if we include balloon loans in the mortgage mixture, we can borrow more from the bank.
Suppose we are a household earning 10,000 NIS net per month. The maximum monthly payment the bank will allow us is 4,000 NIS. If we want to borrow funds on a fixed unlinked loan for 30 years at an annual rate of 4%, we can borrow approximately 837,000 NIS with a payment of 3,995 NIS (we used the PMT function in Excel to calculate this).
Combined with a balloon loan, we can take on a larger debt for the same monthly payment: 700,000 NIS on the mortgage (on the terms described above) plus another 292,000 NIS on a balloon loan at a rate of 2.7% — that's 155,000 NIS more.
The amount we can borrow depends on the purpose of the loan and, in addition, on the value of the property used as collateral.
Sections 2.1 and 2.6 of the Bank of Israel Q&A Directive
We can receive up to 70% / 50% if the purpose of the funds is a substitute dwelling (the purchased property) or an investment property (the existing property), respectively. In addition, the amount we receive depends on the property value net of the outstanding mortgage. We will illustrate this with several examples.
Pricing a balloon loan within a mortgage
How does the bank price the balloon loan as part of our mortgage? Will including it affect the mortgage interest rates?
Impact of the balloon loan on the overall spread of the mortgage portfolio
Because the Bank of Israel doesn't explicitly define this, each bank gets to decide whether the balloon loan is part of the mortgage mixture or a completely separate mortgage.
If it's a completely separate mortgage, the terms of the balloon loan have no bearing on the spread of the mortgage loan. But if the balloon loan is part of the mortgage mixture, it does affect the spread of the mortgage loan.
Impact of the balloon loan on portfolio characteristics
Taking a bridge loan affects two main parameters of the portfolio:- Payment-to-income ratio (PTI): If the balloon loan runs longer than 18 months, it factors into the payment-to-income ratio (LTI - Loan to income ratio), and that increase can push up the interest rates we get.
- LTV on the purchased property: If the balloon loan is taken against the purchased property, it raises the overall LTV of the mortgage and can therefore hurt the quality of the interest rates we get.
- Example A: Say we buy a property worth 1,000,000 NIS and want a mortgage of 300,000 NIS and a bridge loan of 200,000 NIS. Our total debt is therefore 500,000 NIS, and we'll get mid-range interest rates (between 45% and 60% LTV). Without the balloon, we'd have been in the lowest LTV bracket (below 45% LTV) and gotten better rates.
- Example B: Say we buy a property worth 1,000,000 NIS and want a mortgage of 600,000 NIS and a bridge loan of 100,000 NIS — total debt of 700,000 NIS. Here we're already in the highest LTV bracket from the start, so adding the balloon loan doesn't affect the interest rates we get.
Planning optimizations with balloon loans
The balloon loan is an inferior instrument compared to a standard mortgage. It usually comes at higher interest rates (relative to regular mortgage loans), and on top of that you pay only interest, not principal. It can feel like money thrown away every month. But you can definitely turn those lemons into lemonade. Here are several strategies for optimizing mortgage planning alongside balloon loans.- Because the balloon loan is short-term while the mortgage is long-term, it's worth considering (when the balloon loan is part of the mortgage) raising the rate on the balloon loan (worsening its terms) in exchange for a lower rate on the mortgage (improving its terms).
- To avoid raising the LTV against the purchased property, aim to take the balloon loan against the existing property first, and only then against the purchased one.
- To avoid hurting the payment-to-income ratio, try to keep the term of balloon loans under 18 months.
- If you do need a balloon loan against the purchased property, the timing of when you take it can affect the interest rates. Consider taking the mortgage first and the balloon loan afterward (so as not to hurt the payment-to-income ratio).
Should you choose a CPI-linked or unlinked balloon loan?
You need to build out the balloon loan too. Do we want the loan to be CPI-linked or not? There are pros and cons to each. If we choose a CPI-linked loan, our cash flow during the balloon period is easier — we don't pay a high monthly payment. On the other hand, the principal grows with inflation.
Conversely, if we take an unlinked loan, the monthly payment during the balloon period is larger, but the principal does not grow.
What does this actually mean? Choosing a CPI-linked loan eases our cash flow, but eats into the future funds we'll have when we pay off the loan. An unlinked loan strains our cash flow but doesn't reduce the funds we'll use to pay it off.
Cost Comparison: CPI-Linked vs. Non-CPI-Linked Balloon Loan
Cumulative Cost Over Time
Want to check how including a balloon loan affects the overall mortgage mixture? Try our mortgage calculator and examine the impact on the monthly payment and the cost of the mortgage.
Good luck!