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What Is A Balloon Mortgage?

Have you decided this is the year to buy a new home? Good for you! When you begin your research for the right mortgage loan for you, you’re going to be focused on finding the lowest terms and interest rates for which you qualify. It’s no surprise, then, that for many soon to be homeowners, the lower payments available with a balloon mortgage are alluring. Balloon mortgages have some great benefits for the buyer, but they also come with significant risks as well. Before you become convinced that a balloon mortgage is the right option, it’s important to do your homework.

Balloon mortgages get their name from the fact they include a lump sum payment - or “balloon” payment - at the end of the loan. Balloon mortgages also differ from traditional mortgages in that they are a shorter loan; usually no more than 10 years, unlike a traditional loan of 15 to 30 years. The monthly payments are smaller for balloon mortgages than in traditional loans because they are either partially or entirely comprised of interest payments only, rather than the combination of interest and principal payments one makes on a traditional mortgage loan. While the interest-only payments alone can be very appealing, it’s important to look at all the angels on a balloon mortgage before determining if it is the right solution for you.

How Does A Balloon Mortgage Work?

In a traditional mortgage, the loan is amortized over the length of the loan (typically a 15- or 30-year term), which is a fancy word for saying that the principal and the interest of the loan will be paid in full at the end of the loan’s term. With a balloon mortgage, there is no amortization.

The borrower makes a small monthly payment, based upon the fact they are only paying the interest due on the loan or a small amount of the principal and a majority of interest. While small payments may sound like a great benefit, they can amount to one big drawback; a large sum payment due at the end, typically tens or even hundreds of thousands of dollars. While there’s typically no penalty for making payments toward the balloon amount early, the large sum can make it challenging for home owners to meet the terms of the loan, and so they usually sell the home to pay back the amount due.

What Is A Balloon Payment Example?

So how does a balloon mortgage work? Balloon payments can function in a couple of different ways. The two varieties include interest only balloon mortgages and interest with small principal payment balloon mortgages.

Let’s say you are interested in a 10-year fixed-rate, interest-only balloon mortgage for an amount of $150,000 at an interest rate of 5%, and you have a down payment of $5,000. In this scenario, you would be looking at a monthly mortgage payment of around $780.00. That’s a reasonable payment, right? It certainly is, but don’t forget, all you’re paying is interest; none of that amount goes to principal, and when the 10 years is over, you still have to pay all that untouched principal back to the tune of roughly $120,000.

Even with a balloon mortgage where you had the same terms as above but were paying an additional amount of $500 a month toward the principal, you’d still be looking at a balloon payment amount of approximately $40,000 at the end. That’s a significant amount of money to come up with for anyone. This is why most borrowers typically end up selling the property at the end of the loan.

What Happens When A Balloon Mortgage Is Due?

When it’s time to pay the piper, the borrower is expected to pay the balloon payment amount to settle the mortgage, and as we’ve seen, that can be a hefty bill. However, there are a few other options available to settle the mortgage other than writing a large check.

One of the more common solutions to dealing with a large payment is refinancing the remaining balloon payment into a new mortgage either with the original lender, or with a new one. If you were diligent about making your payments on time, have maintained a healthy credit score, and the home itself is of greater value than the amount owed, chances are good you would be able to utilize this option.

It’s also possible your balloon mortgage might include an option to delay the payment provided there is no additional mortgage on the property and you’ve been diligent about making all your previous payments on time.

Can You Pay Off A Balloon Mortgage Early?

You can, but you’ll want to check the terms of your mortgage and see if there is a penalty for doing so before you do. When you make the balloon payment early, the mortgage lender loses out on the interest they would have made on your monthly payments, so it’s possible they could have a penalty clause for early payment.

If your mortgage does have a penalty clause, however, it’s still worth getting out your calculator and doing some math. Depending on where you are in the mortgage schedule, it’s possible that the penalty charge might be a better savings for you than continuing to pay the remaining interest payments, so weigh the difference when determining your actions.

What Is A Disadvantage Of A Balloon Payment?

Prior to the mortgage crisis of 2008, balloon mortgages were much more prevalent, in part because of more lax qualifying processes that led to borrowers seeking homes that would normally be out of their price range. While balloon mortgages are still available and even make sense in some circumstances, there are drawbacks, and it’s important to take a look at these when deciding if a balloon mortgage is for you.

High Risk For Both Buyers & Lenders

Balloon mortgages seem like an ideal scenario going in, but they can be very difficult to get out of. Many borrowers who decide to pursue a balloon mortgage go into the loan thinking they will have years of low monthly payments and then easily convert to a standard fixed-rate or adjustable rate mortgage prior to the lump sum payment coming due. Unfortunately, this isn’t always the case. If the value of your home has depleted since you purchased it or if your financial circumstances have changed, refinancing can be a difficult proposition.

These potential hiccups create real risks of foreclosure for both borrowers and lenders. While qualifying for a balloon mortgage is easy, extricating yourself from one can be troublesome.

Difficult To Refinance

If you go into a balloon mortgage thinking it will be a cinch to refinance your loan to a standard mortgage prior to the lump sum coming due, think again. Just like traditional mortgages, refinancing rules have become more rigid since the subprime mortgage crisis, and most expect the borrower to have at least 20% equity in their home in order to qualify. If you had a small down payment and have been paying an interest only balloon mortgage for years, you won’t be anywhere close to having 20% equity in your property. While programs like HARP (Home Affordable Refinance Program) might be able to offer some assistance, this program also has some specific qualifying standards.

Market Changes

While some groups warned about the impending subprime mortgage crisis, many borrowers were caught completely unprepared when the bottom fell out. Changes in the market and fluctuating property values can happen quickly, and if you have an interest only balloon mortgage, you can end up being upside down on your loan because of them. Refinancing a loan can prove exceptionally challenging in these circumstances.

Cannot Build Equity

Building equity is a valuable part of home ownership as is building your own investment in the property. One of the biggest drawbacks of an interest only mortgage is that if you’re not paying any principal on your loan, you’re not building any equity in your home. This makes refinancing or qualifying for a different mortgage difficult, and does little to boost your own financial position.

Are There Any Benefits Of A Balloon Payment?

While there are many drawbacks to a balloon mortgage, they exist for a reason, and can be a very smart choice for someone in the right position to make the most of their benefits.

Able To Afford A Home Faster

If you’ve grown tired of renting and don’t have a significant downpayment saved, a balloon mortgage can be a smart way to get into the home you’ve always wanted. It’s also a valid choice if you’re working on getting your finances in order, as balloon mortgages don’t have the same stringent credit requirements that more traditional loan programs have.

Lower Monthly Payments

The feature that attracts most people to balloon mortgages is that they offer considerably lower monthly payments than traditional mortgages. If you’re working on getting other bills paid down or the house you purchased needs some significant renovations and upgrades, paying smaller mortgage payments for several years can free up the cash flow needed to achieve these goals while still providing the luxury of being a homeowner.

Short Loan Terms

Another draw of a balloon mortgage? Their shorter loan terms. Most balloon mortgages are for five, seven, or ten years at most. If you know you’re only going to be in a home for a few years, having small monthly payments and selling the home before the balloon amount comes due could be a winning solution for you. If you’re confident you will be able to pay the balloon payment at the end of the loan, balloon mortgages also make sense, because you will own your home free and clear within a relatively short time.

A Balloon Payment Mortgage Makes The Best Sense For Borrowers Who Are...

While balloon mortgages are certainly not for everyone, they can be a great fit for people in specialized circumstances and for those who are confident the large balloon payment won’t be an issue.

For real estate investors, balloon mortgages can be a great solution. They allow for small monthly payments, a short-term loan, and the bandwidth to pay off the remainder of the mortgage once they’ve sold or “flipped” the house.

Buyers who plan to receive a large sum of money from an inheritance or an investment in the near future and are looking for a shorter term commitment to a house will also likely find that balloon mortgages could be the golden ticket to home ownership, as they can plan the terms of the large sum payment to coincide with their windfall.

Is a Balloon Mortgage Right for You?

Ultimately, balloon loans are like a pair of running shoes: wonderful when they fit perfectly, troublesome when the fit is just a little off. There is no doubt that they are a great deal riskier than traditional loans, but if you’re ideally looking to have the lowest payments possible and are comfortable with either paying the large balloon payment or finding a way to refinance it, it could be the ideal solution for you.

 

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This page last updated: March 21, 2022