A balloon mortgage allows you to enjoy low monthly payments for several years — with a big catch. Your final payment amount “balloons,” which could result in a bill that is significantly more than what you have been paying. If you understand the risks and unusual features of a balloon mortgage, this loan type can make sense. Still, it’s best to go in with a plan for how you’ll manage the hefty final payment.
If you’re thinking about getting a balloon mortgage, it’s important to know what the final balloon payment entails. This guide will go deeply into the nuances of balloon mortgages, explaining how they operate, their benefits and drawbacks, and how to steer clear of any potential pitfalls related to the final payment.
What is a Final Balloon Payment?
At the conclusion of a balloon mortgage loan term, a sizable lump-sum payment is called a final balloon payment. With balloon mortgages, there are smaller initial payments followed by a much larger final payment, in contrast to traditional mortgages where payments are dispersed equally over the course of the loan. This last payment may be significantly more than the other installments, which could put borrowers in a difficult financial situation.
How Do Balloon Mortgages Work?
Balloon mortgages typically have shorter terms than traditional mortgages ranging from five to ten years. During the initial period, borrowers make smaller payments that primarily cover the interest accrued on the loan. This results in a lower monthly financial burden compared to a traditional mortgage with equal payments. However the outstanding principal balance remains untouched until the final balloon payment is due.
There are two main ways lenders calculate the initial, lower payments:
- Amortization over a period that doesn’t match your loan term: The lender may calculate your payments as if you had a 30-year loan, even though your actual term may be just 15 years. This allows for smaller payments initially, but the remaining balance at the end of the term becomes the balloon payment.
- Interest-only payments: You only pay enough each month to cover the interest charges, leaving the principal balance untouched until the balloon payment is due.
Example of a Balloon Mortgage:
Let’s take a look at a $280,000 loan amount, a 10-year balloon mortgage, and a 6- 80% interest rate. Compared to a fully amortized 10-year loan, the monthly payments are substantially smaller because they are based on a 30-year amortization.
| Year | Monthly Payment |
|---|---|
| 1 | $1,825 |
| 2 | $1,825 |
| 3 | $1,825 |
| 4 | $1,825 |
| 5 | $1,825 |
| 6 | $1,825 |
| 7 | $1,825 |
| 8 | $1,825 |
| 9 | $1,825 |
| 10 | $1,825 |
| Final Balloon Payment: | $240,958 |
Principal and interest payments cause the balance to somewhat decrease, but not nearly enough to pay off the loan by the due date.
Pros and Cons of Balloon Mortgages:
Pros:
- Lower initial payments: This can be attractive for borrowers who need lower monthly payments in the early years of the loan.
- Greater buying power: The lower payments can allow borrowers to qualify for a larger loan amount, potentially enabling them to purchase a more expensive home.
- Shorter underwriting process: Balloon mortgages often have a faster and less stringent underwriting process compared to traditional mortgages.
- Strategic potential for certain industries: Balloon mortgages can be beneficial for businesses or individuals who anticipate a significant increase in income or asset value during the loan term.
Cons:
- Large final payment: The balloon payment can be a significant financial burden, especially if the borrower’s income hasn’t increased as anticipated or if property values have declined.
- Difficulty refinancing: Refinancing a balloon mortgage can be challenging, especially if the borrower doesn’t have sufficient equity in the property.
- Higher interest rates: Balloon mortgages typically have higher interest rates than traditional mortgages due to the increased risk for the lender.
- Foreclosure risk: If the borrower cannot make the final balloon payment, they risk losing their home to foreclosure.
How to Avoid the Final Balloon Payment:
- Refinance the loan: Before the balloon payment is due, borrowers can attempt to refinance the loan into a traditional mortgage with smaller, evenly spread payments.
- Sell the underlying asset: If the balloon payment is tied to an asset like a house, selling the asset before the payment is due can provide the funds to cover it.
- Pay principal upfront: Making additional principal payments throughout the loan term can reduce the final balloon payment amount.
- Negotiate an extension: Some lenders may be willing to extend the loan term, allowing borrowers more time to accumulate the funds for the balloon payment.
Balloon mortgages can be a viable option for borrowers who need lower initial payments or who anticipate a significant increase in income or asset value during the loan term. However, it’s crucial to understand the risks associated with the final balloon payment and have a plan in place to address it before taking on this type of loan. Carefully weigh the pros and cons, consider your financial situation, and consult with a financial advisor to determine if a balloon mortgage is the right choice for you.
A balloon payment mortgage makes the best sense for borrowers who:
If borrowers have the money to pay, they might want to put it somewhere else until the balloon payment is due. Assuming a balloon mortgage in this instance is less hazardous because you have the funds reserved for the last payment.
If you anticipate receiving an inheritance, bonus, or other windfall and can use those funds to pay the balloon payment when it’s due, then a balloon mortgage might make sense. But the lump sum must be assured, not just something you hope or anticipate occurring prior to the last payment.
If borrowers anticipate a rise in income soon, they might consider using a balloon loan to buy a house while their income is still low. For example, a balloon mortgage can help you buy a house without needlessly waiting if you’re a medical student and you think your income will rise dramatically after you graduate.
In order to purchase, renovate, and quickly sell a property, investors who want to flip houses frequently take out balloon mortgages. However, because these loans frequently have high interest rates and fees, you as the borrower need to exercise caution when using them.
For homeowners who intend to sell their property before the lump sum is due after living there for a few years, a balloon payment might make sense. But if the house loses value during that period, you might have to pay the difference between the sale price and the remaining mortgage balance.
How does a balloon loan work?
Low payments are initially offered by a balloon mortgage, but they won’t be sufficient to pay off the entire loan balance. That’s why you have a sizable balance that needs to be paid in full at the end of your predetermined payment schedule. This payment structure is called “non-standard amortization. ”.
Lenders use amortization to determine how much you will have to pay each month if you wish to repay a loan in full over a series of equal payments. When a loan is “fully amortized” over 30 years, the monthly payment required by the borrower to pay it off by the end of that 30-year period is determined.
Generally speaking, a balloon mortgage has a five- or ten-year loan term as opposed to a traditional mortgage. To avoid having to make that sizable final payment at the end of the term, borrowers may intend to sell their house or refinance. Naturally, you can pay off a balloon mortgage early or when the balloon payment is due if you have the money.
Balloon Payment Explained
FAQ
Are balloon payments a good idea?
What happens at the end of a balloon payment?
Why would you have a balloon payment?
Is it worth paying balloon payment?
What happens after a balloon payment is paid off?
At the end of the five to seven-year term, the borrower has paid off only a fraction of the principal balance, and the rest is then due all at once. At that point, the borrower may sell the home to cover the balloon payment or take out a new loan to cover the payment, effectively refinancing the mortgage.
What is a balloon payment?
A **balloon payment** is the final amount due on a loan that is structured as a series of small monthly payments followed by a single much larger sum at the end of the loan period . This
When is a balloon payment due?
A balloon payment is due at the end of a balloon loan’s term. So, if someone takes out a three-year balloon loan, they would make the balloon payment at the end of the three-year period. Once the borrower makes the balloon payment, the loan should be paid off in full.
What happens at the end of a balloon loan?
At the end of the seven-year term, they owe a $175,066 balloon payment. Some balloon loans, such as a five-year balloon mortgage, have a reset option at the end of the five-year term that allows for a resetting of the interest rate, based on current interest rates, and a recalculation of the amortization schedule, based on a new term.