I’m having a little bit of confusion over the definition of a balloon payment as it pertains to the CFA Level I exam. On one page of my reference materials the balloon payment is defined as follows: “When a final payment includes a lump sum IN ADDITION TO the final period’s interest, it is referred to as a balloon payment.” The reference materials further go on to later define a balloon payment as follows: “at the end of the [bullet] loan term, the loan will still have principal outstanding that needs to be paid; this is called a balloon payment.” So, my question is, in a bullet structure loan, what is defined as the balloon payment - the final principal payment or the combination of the final principal payment AND the final coupon payment?
A balloon payment is the final (sizable) payment of principal, not principal and interest.
S2000, your definition of balloon payment (final and sizable payment of principal without interest) pertains to loans in the bullet structure or partially amortized bonds?
Correct me if I am wrong, but a bullet structure has periodic interest payments and a final payment that includes the full principal amount AND interest. Isn’t that the balloon payment as well?
Also, how can the balloon payment be sizable if it would be less than the bullet structure final payment in a partially amortized bond?
It’s quite amazing how lousy the Kaplan materials can be - full of contradictions. Next time I’ll be reading from the CFAI books instead.
Don’t overthink about this. A balloon is just a sizable payment that can be made at any time during the debt tenor (It’s negotiable!). A bank or other debtholder can ask you for a balloon payment at the beginning, at the middle or at the end of a bond or debt. Also, the debt taker can ask for it.
The common use of a balloon payment is on debts that amortize and pay interest at the same time (like a bank loan, a mortgage, etc), with the intention to reduce the regular payment. Because the debt schedule considers a lower amortizable amount prior (and/or after) the balloon payment, the monthly payments can become considerable lower and thus the interest expense.
If you want to use more intuition, you can consider a balloon payment like a programmed debt prepayment.
In the case of a bullet bond, the principal repayment would be a balloon, but come on! it has its own name already… Principal.