Balloon Mortgage

What Is a Balloon Mortgage?

A balloon mortgage is a real estate loan that has an initial period of low or no monthly payments, at the end of which the borrower is required to pay off the full balance in a lump sum. The monthly payments, if any, may be interest only, and the interest rate offered is often relatively low.

Balloon mortgages have short-term advantages but can be risky for homeowners and lenders alike.

Understanding the Balloon Mortgage

Balloon mortgages for homebuyers can be structured with varying terms and maturities and may have fixed or variable interest rates. Some short-term loans may require the borrower to make the principal and interest repayments at the maturity of the loan with no amortization over the life of the loan. In others, a portion of the payments does go toward the principal, reducing it somewhat, but the bulk is still due at the end.

Balloon mortgages can also charge interest-only payments, which allow the borrowers to make low monthly payments before repaying the lump sum when it is due. Balloon mortgages may be issued for a term as short as two years, although terms of five to seven years are more usual.

In one variation on the balloon mortgage. called the balloon payment mortgage, the borrower pays a set interest rate for a certain number of years. Then the loan resets and the balloon payment rolls into a new or continuing amortized mortgage at the prevailing market rates at the end of that term. Balloon payments tend to be at least twice the amount of the loan’s previous payments — and often a good deal more.

Why Get a Balloon Mortgage?

People who expect to stay in their home for only a short period of time may opt for a balloon mortgage. It comes with low monthly payments and a much lower overall cost, since it is paid off in a few years rather than in 20 or 30 years like a conventional mortgage.

Others may intend to stay in their homes and refinance before the balloon payment is due. They may be counting on a higher income by then, and they are sure that they will be able to handle a larger monthly payment. Or they may foresee a fall in interest rates.

Another type of homebuyer who might find the balloon mortgage appealing is a professional whose main income comes as a year-end bonus. If that bonus is a certainty, then it allows the buyer to get into the home earlier.

Balloon Loans for Business

The balloon mortgage is used often by businesses in the construction industry as a way to obtain short-term financing for construction projects without offering collateral. In this case, they are generally short-term loans that have higher interest rates than conventional collateralized business loans.

The construction company might take out a loan for a year or 18 months and then refinance with a lower-rate mortgage, using the newly built structure as collateral.

Examples of a Balloon Payment Schedule

Let’s say you’re taking out a seven-year balloon mortgage of $150,000. You make only interest rate payments in the amount of $531.25 each month. Throughout the life span of the loan, those payments wouldn’t change — but neither would the balance due on the mortgage. At the end of the term, you would owe that $150,000.

Or, let’s say you’re taking out a balloon loan of $300,000 — one with a longer term of 17 years, but also one in which you are paying both interest and principal each month. The payment schedule would look like this:

Payments on a $300,000 Balloon Loan

 Payment

Interest

Principal

Balance

$299,033.93

$298,064.44

$297,091.52

$296,115.15

$295,135.33

$294,152.03

$293,165.25

$292,174.98

$291,181.20

$290,183.90

$289,183.07

$288,178.69

Source: Rocket Mortgage

At the end of the term, there’s a balloon payment of $35,000 — the entire remaining amount of the mortgage.

Risks of Balloon Mortgages

The balloon mortgage can be a risky proposition.

First of all, the homeowner has little or no equity in the house and is counting on selling it or refinancing it for at least the amount of the balloon payment. In a slow or declining real estate market, that might not be possible. Even if it is, that’s not a great alternative for the homeowner, who had intended to sell the house and move on.

If the real estate market goes sour, then the borrower could be in real trouble. In a worst-case scenario, the lender may or may not agree to extend the deadline on the balloon payment or otherwise change the terms of the loan.

Defaulting on a balloon mortgage — as with any mortgage — has serious consequences: The home may be foreclosed upon, and the borrower’s credit score will suffer a major hit.

Refinancing the loan may be difficult, too. Because the borrower has built up less equity in the home than they would have with a regular mortgage, they may seem like a less creditworthy prospect to lenders.

A balloon mortgage has its risks for lenders as well. Because that final payment is such a big amount, the odds are greater that the borrower won’t be able to make it and that the lender will have to foreclose on the property. Also, because the monthly payments are lower, lenders don’t get as significant a cash stream from the loan.

How to Pay Off a Balloon Loan

Borrowers generally have three options when it comes to paying off a balloon mortgage:

Settle it. The simplest thing — if you can afford it — is just to pay the remaining principal in full. Ideally, you would have been thinking ahead to doing this when you took out the loan: saving and investing with this short-term time frame in mind. Or, perhaps you knew that your income would have dramatically risen by this point, or that you’d receive a windfall sum (pension plan distribution, trust payout, etc.).

Refinance it. Pay off this mortgage by taking out another mortgage — probably, a more conventional fixed-rate mortgage that amortizes over its term. This strategy works if you have built up a decent amount of equity in the home, have a steady income and or other assets, and have a good credit history. Bear in mind that your monthly payments will be bigger.

Sell the home. Use the proceeds to pay off the debt. Many people who opt for balloon mortgages were only planning to be in that home for a few years — roughly the term of the loan — anyway. House flippers — people who buy, renovate, and sell residences — find balloon mortgages their finance vehicle of choice, too.