Promissory notes with balloon payments are a financing option you may be considering for your business. These types of loans may be secured by collateral or not, but they always end their repayment schedule with a big payment, known as the balloon payment. Reviewing the pros and cons of this scheme can help you make a decision about what may be best for your business.
Understanding Promissory Notes
A promissory note is a loan agreement between a lender and a borrower. The lender provides money to the borrower, who promises to pay it back.
Some promissory notes are secured, which means that collateral is placed against the loan (for example, a car loan has the car as collateral). With a secured note, a piece of property serves as security for the loan—your business could use a piece of equipment as collateral. If the borrower does not pay the loan back, the lender can take possession of the property.
Promissory notes can also be unsecured, which means there is no collateral backing the loan.
How Balloon Payments Work
Conventional loans are set up so that the borrower makes regular payments throughout the life of the loan, made up of interest and principal (amortized to create equal payments). When the final payment is made, the entire loan is paid off.
When a loan has a balloon payment, it means that the regular payments are generally made up of interest only—which makes the payments smaller—and the very last balloon payment on the loan is the entire principal of the loan.
Pros of Balloon Payments
Balloon payment promissory notes do have some advantages to consider:
- The regular loan payments (up to that big balloon payment) are smaller, since they are interest only. This can allow a small business time to build up its profitability before having to pay back the principal.
- A balloon payment loan can be a good alternative if your business lacks credit. The loan may give you additional time to build up your credit.
Cons of Balloon Payments
There also are drawbacks to balloon payment promissory notes that should be considered:
- Unsecured loans with balloon payments usually have a higher interest rate than conventional loans.
- Paying that large balloon payment at the end of the loan may be financially difficult for your business.
- If the balloon payment loan has collateral and your business is unable to make the final payment, you will lose the collateral.
Final Payments on Balloon Loans
When your business makes the balloon payment on your loan, it is the final payment and the loan will be completely satisfied. The lender should give you a final payment letter or final payment release form, showing that the loan has been paid.
Creating Promissory Note Balloon Payment Loans
While the lender can draw up the promissory note document, it may be best to have an attorney or an online service provider create the document, so that it complies with state laws and is legally enforceable.
Promissory notes with balloon payments can be a good source of funding for your business if you carefully weigh the pros and cons. Be sure to consider a variety of options before choosing funding for your venture.