How does a balloon mortgage work?
A balloon mortgage can work in several different ways, but you’ll always have to make one big balloon payment at some point. Here are some ways balloon mortgages can be structured:
Balloon payment mortgage
This is the most common type of balloon mortgage. Loan payments are calculated according to a normal 15- or 30-year amortization schedule. However, after a certain time period — say five or seven years — the remaining principal is due in one lump sum.
Let’s say you’re borrowing $200,000 to buy a home. You choose a balloon mortgage with a 3% interest rate, amortized over 30 years, with a balloon payment due after seven years. Your monthly mortgage payment would be $1,079 toward principal and interest, according to The Ascent’s mortgage calculator. After the seven-year mortgage term, a principal balance of $167,561 would remain. And it would all be due at once.
You’ll pay only interest on some balloon mortgages for the repayment period. This means borrowers pay only the monthly interest on the loan. The entire original principal balance is due at the end. This is most common in commercial real estate but isn’t unheard of in the residential mortgage market.
No monthly payments
There are also balloon mortgages with no monthly payments at all. These are usually short term (say, one-year). The interest that accumulates is then added to the final balloon payment. These balloon mortgages are often seen in fix-and-flip situations, where a year or two of interest is viewed as a part of a rehab project’s cost.
How do balloon mortgages compare to other loan types?
Balloon mortgages carry more risk than other loan types, but there’s usually a specific factor that appeals to borrowers. For example, a balloon loan might have a lower interest rate. Or, it could be an interest-only loan product. In either of these cases, the monthly payment could be lower.
- Conventional loans. The main difference between a balloon mortgage and conventional loan is predictability. You know exactly what your payment will be, and how long you’ll make payments. And you know when your home will be paid off. For more on which is right for you, visit our comparison of a 15 vs. 30-year mortgage.
- Adjustable-rate mortgages. The interest rate on an adjustable-rate mortgage is fixed for a certain number of years (often five or seven). After that, it adjusts periodically based on market conditions. Most balloon mortgages have fixed rates, because of the short-term nature of their maturity terms. An adjustable-rate mortgage may be a good alternative to a balloon mortgage. You won’t have to make a big lump-sum payment if you’re unable to sell or refinance after that initial period.
- Government-backed loans. FHA loans and USDA loans are not available as balloon mortgages. An FHA loan is aimed at borrowers who might not be able to qualify for a conventional mortgage. This could be because their credit score is lower or they can’t make a large down payment. A USDA loan could help low-income borrowers in certain rural areas qualify for a home loan.
The biggest risk of a balloon mortgage is what could happen at the end of the term. Unlike some of the other loan types, you’ll owe a substantial amount of money all at once. If you can’t pay it, you risk damaging your credit and potentially losing your home.
When are payments due for balloon mortgages?
This depends on the specific loan. Seven-year balloon mortgages seem to be the most common, but you’ll also find five-year and 10-year repayment terms. Balloon mortgages as short as three years, or as long as 30 years are possible as well.
In any case, the last payment of a balloon mortgage will be the lump sum of whatever principal and accrued interest is outstanding on the account.
In most cases, the borrower doesn’t actually plan to make the balloon payment. Instead, the goal is to refinance the remaining balance or sell before the balloon payment comes due.
- Selling your home. You may want to sell the home before you have to pay that lump sum. But there’s no guarantee you’ll be able to. Even if you can sell, there’s no way to know whether the home’s value will increase or decrease. Nobody can predict what real estate market conditions will be in five or seven years.
- Refinancing. Some people take out a balloon mortgage with a plan to refinance before the final payment comes due. That’s an option, but be aware that interest rates could rise dramatically between now and then.
When a balloon mortgage might be a good idea for you
Balloon mortgages make the most sense for borrowers who only plan to own the home for a short period of time. This is especially true if you can find an interest-only balloon mortgage. Even then, balloon mortgages can be quite risky.
Some cases where balloon mortgages can make sense:
- Your credit isn’t great now, but you’re confident it will be significantly stronger in the future. This would allow you to refinance before the balloon payment comes due.
- You only plan to be in the home for a few years and want to keep your monthly housing expense as low as possible.
- You think interest rates will fall significantly over the next few years and plan to refinance at a lower rate in the future.
View more information: https://www.fool.com/the-ascent/mortgages/balloon-mortgages/