Many people would prefer to forget the Great Recession, which started in 2008 when the housing market collapsed as a result of the subprime mortgage crisis. But significant catastrophes like this are not quickly forgotten, especially when the economy is severely impacted.
In fact, individuals will continue to recall that beneath all the debris, thousands of balloon loans that went bad serve as the primary antagonist. Many people today do not fully comprehend what a balloon loan is, or how a seemingly unimportant loan could almost bring down a major economy.
For many people their mortgage is their largest debt. Mortgages are the most popular form of financing for real estate purchases, and according to Experian, the amount owed on these loans in the USA is steadily rising. Using Experian data, you can see that mortgage loan debt has increased in this graph over the past ten years, going from $8. 2 trillion in 2010 to $9. 5 trillion in 2019. Despite a decline in 2011 and 2012, there has been an overall upward trend.
Balloon Mortgage Overview
A balloon mortgage differs from other loans in that it doesn’t fully amortize over the course of the loan, which makes it unique. With a balloon mortgage, the borrower must pay off the entire balance in one lump sum at the end of a loan with a short or no monthly payment term.
Ideally, the borrower will make payments over a predetermined period of time (typically five or seven years) and then pay off the entire remaining balance of the loan all at once at the conclusion of that time. It stands to reason that the remaining balance would be substantial, thus the term “balloon payment.”
Borrowers who take out balloon loans pay interest for the first few years but don’t make principal payments. It is understandable why many financial experts also refer to them as “interest-only” loans. With a conventional loan, you are aware that your monthly payments will cover the loan’s partial principal as well as the monthly interest.
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So you can see that this plan requires the borrower to make much smaller monthly payments. Mortgages typically have a balloon loan structure, but it is not uncommon for borrowers to use the plan for other large loans, like auto loans.
Most balloon loans are spread out over a standard 30-year period to calculate the monthly payments, but some lenders use different computation techniques, such as interest-only calculations. Some balloon loans have a “reset” option that becomes effective at the loan’s conclusion.
By asking for a reset, the borrower instructs the lender to automatically recalculate the mortgage at the current interest rate. However, if such a choice is absent, it might indicate that the buyer will either sell the house or refinance it prior to the term’s end.
Balloon Mortgage – Example #1
Suppose a buyer obtains a seven-year balloon mortgage to purchase a house. Then, for the following seven years, the lender will expect him to make equal monthly payments at a fixed interest rate. Frequently, the rate will be much lower than a conventional mortgage loan.
The lender will request the borrower to pay the remaining loan balance at the conclusion of the seven-year period. The borrower has three options: paying it off in full, refinancing with the lender (or a different lender), or just selling the property.
Balloon Mortgage – Example #2
Let’s examine what will transpire if a borrower takes out a $300,000 balloon loan with a 7-year term and a 4 percent interest rate. 5% with an amortization period of 30 years. He will only make payments for seven years out of the thirty required to pay off the loan. 84 months of payments would then leave him with a balance of $262,598.
This is the total sum that the borrower will be required to pay in one go.
Balloon Mortgage Payment Schedule – Example
A $250,000 balloon mortgage provided at 4% with a 6-year term and a 30-year amortization is used as the basis for the example that follows:
| Month | Payment Amount | Principal | Interest | Balance Remaining |
|---|---|---|---|---|
| 1 | $1,193.54 | $360.21 | $833.33 | $249,639.79 |
| 2 | $1,193.54 | $361.41 | $832.13 | $249,278.38 |
| 3 | $1,193.54 | $362.61 | $830.93 | $248,915.77 |
| 70 | $1,193.54 | $453.18 | $740.36 | $221,654.00 |
| 71 | $1,193.54 | $454.69 | $738.85 | $221,199.31 |
| 72 | $1,193.54 | $456.21 | $737.33 | 220,743.10 |
The borrower would make regular monthly payments of $1,193. 54 according to the plan above. If the borrower continued to make those payments for 30 years, the loan would be fully repaid. This loan, however, is just for five years. The borrower would be left with a balance of $220,743. At the end of the five-year loan term, they would be required to repay 10 in a single lump sum.
Mortgage debt accounts for the majority of consumer debt. The average mortgage loan debt has steadily increased between 2015 and 2019, according to this 2020 NAR Trends chart. A notable 10% growth has occurred in this market over the past four years. This implies a pattern of rising mortgage debt that is associated with an increase in home prices.
The Pros and Cons of Balloon Mortgages
This is an appropriate financing plan for borrowers seeking low, fixed interest rates on their loans. Because it typically only lasts for 5 to 7 years, this type of mortgage is also comparatively shorter than other loans. However, the borrower should be aware that there will be a sizable remaining loan balance at the end of the term that must be paid in full.
So, if you plan to buy a home and anticipate a windfall or want to earn more money in the near future, this may be for you. Or, if you frequently move or have no intention of staying in your newly purchased home for an extended period of time, you may benefit from this type of mortgage.
The main advantages and risks of using this type of home financing are listed below:
Balloon Mortgage – Advantages
First and foremost, the low down payment is what draws borrowers to this type of loan. The inclusion of this feature actually increases the number of borrowers who qualify for the loan.
This alternative home financing program is therefore ideal for borrowers who may be short on cash right now but anticipate receiving a sizable sum of money in the next five to seven years.
Low-Interest Rates
It goes without saying that if you obtain a loan with a low interest rate, your monthly payments will also be low. This is especially advantageous for a borrower who plans to sell the house later because every expense you incur, including interest, could potentially lower your profit.
Additionally, if you intend to remain in the home, you’ll want to make as few payments as possible to free up some cash for the lump sum when the balloon payment is due or to refinance for a lower sum.
Easy To Qualify
Most people can more easily qualify for a balloon mortgage when compared to a traditional loan when comparing their eligibility requirements. As a result, many more borrowers will have the opportunity to purchase a home.
This is especially attractive for people who are confident that they can refinance before the end of the term because of an impending upward shift in their financial situation such as an anticipated spike in their regular income.
Future Refinancing
It’s conceivable that some borrowers won’t be able to pay off their outstanding balance in full when the mortgage term is up. They can reapply for a resetting or refinancing of their loan balances in this scenario with a balloon mortgage. However, there is a catch: Lenders will refinance using the current market rates rather than the lower initial loan rates.
Therefore, borrowers will have to pay more each month than they did for their initial loans.
Balloon Mortgage – Disadvantages
Any type of home financing carries some risk of foreclosure, but a balloon mortgage carries a notably higher risk. Directly identifying the potential problem areas is simple.
First, the lump sum becomes due on the maturity date, and the borrower might not have enough money to pay back the remaining balance of his loan. Second, if the borrower is unable to meet the requirements for a refinancing This will make things more challenging and increase the likelihood of a foreclosure.
In the 2008 mortgage crisis, a material number of borrowers with balloon mortgages went through foreclosure because they were not able to pay for the remaining balance of their loans. Many failed to get refinancing and because of the crisis, it was almost impossible to get a good price for your house let alone be able to sell it.
Easy To Qualify
Many borrowers find it very alluring to be able to apply for a loan without having to endure a taxing screening procedure. This could cause major problems for those who do not have a secure assurance that they will be able to afford a lump sum payment on the maturity date.
They might eventually face pressure to sell their home for a loss or let it go due to foreclosure. Naturally, they might be fortunate and be able to sell it for a profit, but that is essentially wishful thinking. They may learn a few important lessons about caution and planning from it, but they still have to deal with the fact that they lost their home as a result of their own foolishness.
Huge Payment at Once
This is probably the most compelling reason why you should not just jump right in and get a balloon loan: you will have to make a substantial payment at maturity. So, if you really want this type of mortgage, you have to be absolutely certain that by the end of the term, you will have enough money to pay off the balance – otherwise, you’ll be setting yourself up for a disaster.
Just keep in mind that it might be nearly impossible for a typical family to raise that amount of money within 5 to 7 years to cover the balloon payment.
Conclusion
Balloon loans are unquestionably much riskier than traditional loans from all perspectives. You can go for it if your main goal is to reduce your housing expenses as much as you can and you are confident that you can leave before the balloon payment is due. However, if your financial situation is a little precarious and you’re the type to worry endlessly that you won’t be able to refinance or sell in time, consider your options carefully. You may be better off going for a traditional loan.
What you intend to do with the home and how you intend to repay the loan should be taken into consideration when deciding how to buy it. The likelihood that you will receive a raise within the next two years and your ability to refinance easily are positive factors. The only thing left to do is maintain a perfect credit score up until that point. If you fit these criteria, a balloon mortgage is a fantastic choice.
Thoroughly evaluate your circumstances now, your financial situation, and your future income potential before you make a decision.
You can seek assistance from your lender in selecting the ideal mortgage for you. They will be more than happy to discuss the advantages and disadvantages of a balloon mortgage with you so you can make an intelligent choice.
FAQ
What are the disadvantages of balloon mortgage?
- Pay a large amount at once. Low monthly payments have the drawback of requiring a sizable payment at the end of your balloon mortgage term.
- High risk. There are several risks associated with a balloon mortgage.
- Difficult to refinance. …
- Hard to find.
What are the pros and cons of a balloon mortgage?
There are some advantages to balloon loans. These loans frequently provide access to low interest rates for borrowers. However, there is no assurance that the borrower will be able to refinance at that lower rate—or even that they will be able to refinance the loan at all—so the drawbacks frequently outweigh the benefits.
What is a disadvantage of a balloon payment?
The disadvantages of promissory notes with balloon payments should also be taken into account. Unsecured loans with balloon payments typically have interest rates that are higher than conventional loans. For your company’s finances, making that hefty balloon payment at the end of the loan could be challenging.
What is the advantage of a balloon mortgage?
The main benefit of a balloon mortgage is that the interest rates are typically lower, resulting in lower monthly mortgage payments. A balloon mortgage may also allow you to qualify for a larger loan amount than you would with a fixed-rate or adjustable-rate mortgage.