What is a Balloon Mortgage?
A balloon payment mortgage is a loan with monthly payments based on a long term, but the loan itself is only for a shorter time period, typically 5-7 years. Borrowers make regular monthly payments for the loan term.
At the end of the term, the entire remaining loan balance must be paid off with a large final payment, called a balloon payment. This final payoff is much bigger than the previous monthly installments.
With a balloon mortgage, you only make payments on a portion of the debt over the loan term. You still owe the full amount borrowed, due as a balloon payment at the end.
For example, you might take out a 30 year $200,000 fixed mortgage, but with a balloon payment structure. You would make payments over 7 years based on the 30 year schedule. At the end of 7 years, you must pay the outstanding loan balance, which could be $180,000.
This balloon payment is called “due on maturity.” You must pay the lump sum when the loan reaches the end of the term. Otherwise, you default on the mortgage.
A balloon mortgage is different from fully amortized loans like a typical 30 year fixed rate mortgage. With a fully amortizing loan, the monthly payments are calculated to pay off the entire loan balance over the full term. There is no large balloon payment due at maturity.
Pros of Balloon Payment Mortgages
What are the benefits of a balloon mortgage? There are a few potential advantages that make adjustable payment mortgages with balloons appealing:
Lower Monthly Payments
The main advantage of a balloon loan is the lower monthly payment. By only amortizing part of the total mortgage amount, the monthly payments are lower compared to a fixed rate mortgage for the same loan and home.
This can make it easier to qualify for the monthly payments with a balloon mortgage. The part that isn’t amortized won’t accrue interest over the loan term. Not paying interest on the full balance results in smaller installments.
Shorter Loan Term
Balloon mortgages often have shorter loan terms, like 5-7 years. This results in paying off the loan faster. You may be able to get into another mortgage with better terms when it comes time to make the balloon payment.
Interest Rate Advantages
These types of loans sometimes offer lower interest rates as well. Lenders consider balloon mortgages riskier, so they may offer lower rates to compensate and attract borrowers.
The interest rate may be fixed or adjustable. A fixed rate holds steady, while an adjustable rate mortgage (ARM) fluctuates along with an index like the prime rate. ARMs sometimes have appealing teaser rates for an initial period.
Flexibility
Because it’s only a 5-7 year loan, your life circumstances could change a lot over that time. A balloon mortgage leaves flexibility to make a major move like selling your home before the term is up.
If you need to move in a few years, you may be able to sell the house, pay off the loan, and walk away free and clear. There’s flexibility if your plans change.
Cons of Balloon Payment Mortgages
While there are some potential upsides, balloon mortgages also come with considerable risks. Here are some key cons to consider before signing up for a balloon loan:
Balloon Payment Risk
The need to come up with the large payment at maturity is the biggest downside. Balloon amounts are often tens of thousands of dollars or more. You need to pay off sometimes almost the entire original loan amount at once.
This payment could be more than you can save or borrow if your finances don’t improve significantly. Coming up with such a big payment may not be feasible.
Refinancing Difficulties
Most people plan to refinance the balloon payment into a new loan. But if interest rates rise or your credit score drops, you may not qualify to refinance in time.
Lenders have tightened requirements since the housing crash, making it harder to refi. You could get stuck with the balloon and no way to pay it.
Shorter Loan Term
While a faster payoff seems good, the shorter term also ramps up payment shock risk. If you want to keep the home long term, you’ll need to refinance every 5-7 years when each balloon comes due.
Prepayment Penalties
Some balloon loans impose prepayment penalties if you refinance earlier than scheduled. This adds to the cost of refinancing before maturity.
Higher Long Term Costs
Even with lower rates upfront, your total interest costs over time are usually higher compared to a fixed rate mortgage for the full term. Repeated refinancing involves fees and closing costs.
Require Lump Sum Funds
You must have the large payment amount available when the balloon comes due. Even if you can refinance, you may need to come up with 10-20% of the balance as a down payment for the new loan.
Tips for Managing a Balloon Mortgage
If you decide on a balloon payment mortgage, here are some tips to manage the risks:
- Get quotes to refinance well in advance of maturity, at least 6 months out or more
- Start saving for the balloon payment as soon as possible
- Pay extra principal to reduce the amount due at maturity
- Shop multiple lenders to find the best refinance rates and terms
- Maintain excellent credit to qualify for refinancing when needed
- Review your budget to ensure you can afford higher payments if rates rise
- Consider a HELOC as a backup payment option if you have enough home equity
- Know when you have to pay – mark your calendar so you don’t miss the deadline
- Understand any prepayment penalties and factor them into the costs
- Be prepared to sell your home or tap other assets if needed
With proper planning and preparation, you can benefit from the lower payments while minimizing balloon payment risks. But make sure you go in with your eyes open understanding the pros, cons and obligations.
Key Takeaways:
- A balloon mortgage has lower monthly payments but requires a large lump sum payment at the end of the loan term
- Benefits include lower payments, faster payoff, and potentially lower rates
- Drawbacks are the risk of not being able to make the balloon payment, needing to repeatedly refinance, and higher long term costs
- Manage balloon risks by saving up, maintaining your credit, thoroughly researching lenders, and having backup payment plans
- Balloon mortgages can be a good option but only if you fully understand the commitment and prepare for the balloon payoff when it comes due.
Calculate Here Your Ballon Payment Mortgage
Frequently Asked Questions?
A: A balloon payment mortgage is a type of loan that requires the borrower to make small monthly payments for a fixed period of time, usually 5 to 7 years, and then make a large payment, known as the balloon payment, at the end of the loan term.
A: The pros of a balloon payment mortgage include lower initial monthly payments and the ability to buy a home with a lower interest rate. However, the cons include the risk of defaulting on the loan if you are unable to make the balloon payment and the need to refinance or sell the home to pay off the balloon.
A: There are several ways to pay off a balloon mortgage. You can refinance the loan into a fixed-rate or adjustable-rate mortgage, sell the home to generate enough funds to pay off the balloon, or make the balloon payment from savings or another loan.
A: Sure! Let’s say you take out a balloon loan for $200,000 with a 5-year term and a 10% interest rate. Your monthly payments would be around $1,073. After 5 years, you would owe a balloon payment of approximately $180,805.
A: To get rid of a balloon payment, you can refinance the loan into a different type of mortgage that doesn’t have a balloon payment, sell the home to pay off the balloon, or make the balloon payment from savings or another source of funds.
A: The cons of a balloon payment mortgage include the risk of defaulting on the loan if you are unable to make the balloon payment, the need to refinance or sell the home to pay off the balloon, and the potential for higher interest rates if you refinance after the balloon payment comes due.
A: Yes, you can refinance a balloon mortgage. Refinancing involves replacing the current loan with a new loan that has different terms, such as a fixed-rate mortgage or an adjustable-rate mortgage.
A: If you are unable to make the balloon payment, you may be at risk of defaulting on the loan. Defaulting on a loan can have serious consequences, such as damaging your credit score and potentially losing your home if the lender initiates foreclosure proceedings.
A: An adjustable-rate mortgage, also known as an ARM, is a type of mortgage loan where the interest rate can change over time. The interest rate is typically fixed for an initial period, such as 5 years, and then adjusts annually based on market conditions.
A: The balloon payment is due at the end of the loan term. This means that after making the initial monthly payments for a fixed period of time, the borrower is required to make a large lump-sum payment to pay off the remaining balance of the loan.
