Mortgages come in many varieties. One lesser-known type of mortgage is the balloon payment mortgage, sometimes called simply a balloon mortgage. Often a mystery to home buyers, this type of mortgage comes with unusual terms, a potential for huge savings, and enormous risk.
What Is a Balloon Mortgage?
A balloon payment mortgage is a short-term home loan with low monthly payments where the bulk of the loan is due at the end of the loan period.
Unlike a typical mortgage, the balance of a balloon mortgage isn’t designed to fully amortize — reduce to $0 through debt payments — throughout the loan payment term. Instead, the borrower pays the majority of the loan off in one lump-sum payment at the end of the term.
How Does a Balloon Mortgage Work?
Balloon loans can be any loan with a lump-sum payment schedule, including auto loans, personal loans, and mortgages. The lump sum can be due at any point during the loan term, but it’s most often due at the end.
Balloon mortgage terms can be as short as 18 months, but they’re more typically five to seven years.
Monthly payments throughout the loan term are either:
- Interest Only. You pay interest that accrues each month, so your payment at the end is the full amount you borrowed.
- Balance and Interest. You’ll make payments toward the interest and principal, so your payment at the end is less than the full amount you borrowed.
If you make balance-and-interest payments, your monthly mortgage payment is similar to what you’d pay with a 30-year mortgage, except the balance comes due after just a few years.
If you make interest-only payments, your monthly payment is lower than what you’d pay with a typical mortgage, and you owe the amount you borrowed in one lump sum after a few years.
Balloon mortgage rates are often lower than those for longer-term mortgages, and balloon mortgages can be fixed-rate or variable-rate loans. Balloon mortgages tend to come with lower closing costs, so they may be easier to afford or qualify for than a typical mortgage.
Example of a Balloon Payment
Say you’re purchasing a house for $250,000. You make a down payment of $50,000 and borrow a $200,000, seven-year balloon payment mortgage at a 4.5% fixed interest rate.
If you make balance-and-interest payments of $1,013 per month for 83 months, you’ll owe a balloon payment of $175,066 after seven years, according to the balloon mortgage calculator from MortgageCalculator.org. You’ll have paid $59,176 in interest.
With the same mortgage on a typical 30-year term, you’d pay $1,013 per month. Over the life of the loan, you’d pay back the $200,000 you borrowed plus $164,680 in interest.
What Happens If You Can’t Pay a Balloon Payment?
Balloon payment mortgages present a risk for homeowners because you count on being able to afford a large payment five or seven years down the road. However, borrowers have options to get rid of a balloon payment.
How to Get Rid of a Balloon Payment
You have four main options to meet or eliminate your obligation to a balloon mortgage payment:
- Pay It Off. The simplest — but maybe not the easiest — option is to stick to the original plan and make the balloon payment to pay off your loan.
- Sell the Home. If you can sell the home for more than what you owe in a balloon payment, you can pay off the mortgage and profit from the home sale.
- Refinance. Borrowers commonly refinance the mortgage before the balloon payment comes due. This can change the interest rate and extend the repayment term to set you up with ongoing monthly payments.
- Reset. A balloon payment mortgage might come with an option to reset at the end of the term. These are sometimes called “convertible” balloon mortgages, and the lender writes the terms when you take out the original loan. For example, a 3/27 convertible balloon mortgage will start with three years at the original interest rate and then give you the option in year four to pay the balance or convert the loan to a fixed-rate, fully amortized 27-year mortgage with a new interest rate based on market rates.
Selling a Home With a Balloon Payment Mortgage
Homeowners who plan to sell quickly after buying a property often benefit from the low interest and low monthly payments of a balloon payment mortgage. You save money as long as you can sell the home at a profit before the balloon payment comes due.
This plan can benefit home buyers who plan to move within a few years, buyers who want to flip properties for a profit, and commercial developers who want to build on and sell property.
The risk in this plan is the timing. You could end up needing to sell a property in a down market when prices are low or buyers are scarce. You lose money or face foreclosure if you can’t sell for more than what you owe on the mortgage.
Refinance vs. Reset
Refinancing or resetting a balloon mortgage lets a borrower enjoy the initial low-interest, low-payment period while avoiding the balloon payment.
Accepting a convertible balloon mortgage now could put you at a disadvantage if you expect your credit to improve over the next few years. The lender sets the reset terms based on your current credit score, so interest and terms might be less favorable than you’d get by refinancing to a new loan.
Refinancing down the line when you’ve built better credit seems wise, but you risk needing to refinance during a period when market rates are high. Signing up for a 30-year fixed-rate mortgage in the first place could prove more financially beneficial.
Refinancing might be your best option, though, if you can’t afford to make the balloon payment when it’s due. In that case, even a higher interest rate is better than foreclosure.
Is a Balloon Mortgage a Good Idea?
Balloon mortgages come with risks and rewards that make them a good or bad fit for different types of buyers.
Pros
- Interest rates are often lower than with standard 30-year fixed-rate mortgages.
- This type of mortgage is often easier to qualify for.
- Closing costs are often lower.
- Monthly payments are lower, especially if you make interest-only payments.
- You pay less in interest over the life of the loan.
Cons
- You must pay back the bulk of the loan — potentially hundreds of thousands of dollars — in one payment.
- Counting on selling the home, refinancing, or resetting the loan risks unfavorable terms in a poor market.
- Interest-only payments don’t let you build home equity.
Who Should Get a Balloon Payment Mortgage?
Because of the risk for borrowers, balloon mortgages are more common in commercial real estate — where businesses can absorb ill-timed balloon payments — than for private home buyers. But some private home buyers can benefit from this type of mortgage too.
A balloon payment mortgage might be right for you if:
- You Move Often. When you know you’ll sell your home within seven years — regardless of the market — a short-term loan might make sense.
- You Flip Houses. When you buy a home intending to sell it in a year or so, a balloon mortgage could help you get started with lower upfront costs.
- You’re Early in Your Career. If you expect to have significantly higher income within a few years and could afford a balloon payment or higher monthly payments after resetting the mortgage, the loan could be a good fit.
- You’re Building Credit. If you expect to improve your credit in a few years, you may be able refinance the loan later to a longer term at a more favorable interest rate, depending on market rates in the future.
An adjustable-rate mortgage (ARM) — which starts with a period of three to seven years at a low fixed interest rate and then switches to a variable rate for the remainder of the loan term — can offer most of the same benefits with less risk than a balloon mortgage. However, an ARM might come with higher closing costs and be tougher to qualify for.
Final Word
When they first came on the market, balloon mortgages were only available to real estate investors. They generally make sense for home buyers who plan to flip a property quickly to ensure they have enough money to make the balloon payment. These mortgages offer the benefit of low closing costs, low interest rates, and low monthly payments, making home investment more affordable.
Now that balloon mortgages are available to home buyers for any property, you have the option to use one for your primary residence. But the benefits largely disappear if you plan to stay in your home beyond the length of the loan.
Lenders might promote balloon mortgages to borrowers with poor credit as a way of getting a favorable interest rate, but beware the risks. If you can’t afford the balloon payment when it’s due, you could face foreclosure. Or you’ll have to refinance the mortgage and risk less favorable terms. Consider an adjustable-rate mortgage or other options for low-income home buyers to get similar benefits without the risk.
Source: moneycrashers.com