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.
A balloon loan is a type of loan that doesn’t fully amortize over its term, meaning you don’t pay off the entire principal balance through regular payments Instead, you make smaller payments during the loan term, and then a large lump sum payment (known as the balloon payment) is due at the end This final payment can be a significant portion of the original loan amount.
Balloon loans can be attractive to borrowers who want lower monthly payments, but they also come with risks. It’s crucial to understand how these loans work and whether they’re the right choice for your financial situation.
How Does a Balloon Loan Work?
Here’s a breakdown of how balloon loans typically function:
- Shorter Loan Terms: Balloon loans usually have shorter terms than traditional loans, often ranging from five to seven years.
- Lower Monthly Payments: During the loan term, you make payments that are typically lower than those on a traditional loan with the same interest rate and term. This is because the payments only cover the interest and a small portion of the principal.
- Large Balloon Payment: At the end of the loan term, you’re responsible for making a large balloon payment that covers the remaining principal balance. This payment can be a significant financial burden, and it’s essential to have a plan in place to cover it.
Example of a Balloon Loan
Assume for the moment that you obtain a $200,000 balloon mortgage with a four-year term and a 5% interest rate. Your monthly payment for seven years would be $1,013. But after the seven years, you would have a $175,066 balloon payment to make.
Special Considerations for Balloon Loans
- Refinancing Risk: Since balloon payments are large, there’s a risk that you won’t be able to refinance the loan at the end of the term, especially if interest rates have risen. This could leave you scrambling to come up with the funds for the balloon payment.
- Default Risk: If you can’t make the balloon payment, you could default on the loan, which would damage your credit score and potentially lead to foreclosure or repossession of your property.
- Reset Option: Some balloon loans have a “reset option” that allows you to refinance the loan at the end of the term with a new interest rate and payment schedule. However, this option isn’t always available, and the new interest rate could be higher than the original rate.
Pros and Cons of Balloon Loans
Pros:
- Lower Monthly Payments: This can be attractive for borrowers who want to free up cash flow in the short term.
- Flexibility: Balloon loans can offer flexibility for borrowers who plan to sell the property or refinance the loan before the balloon payment is due.
- Potentially Lower Interest Rates: In some cases, balloon loans may have lower interest rates than traditional loans.
Cons:
- Large Balloon Payment: This can be a significant financial burden, and it’s essential to have a plan in place to cover it.
- Refinancing Risk: There’s a risk that you won’t be able to refinance the loan at the end of the term, especially if interest rates have risen.
- Default Risk: If you can’t make the balloon payment, you could default on the loan, which could have serious consequences.
Frequently Asked Questions (FAQs)
1. When are balloon loans allowed?
Mortgages are the usual purpose for balloon loans, but they can also be used for other kinds of loans, like business and auto loans. But depending on the lender and the kind of loan, there might be limitations on balloon loans.
2. How do I know if a balloon loan is right for me?
It’s important to carefully consider your financial situation and the risks associated with balloon loans before taking one out. Ask yourself the following questions:
- Can I afford the monthly payments?
- Do I have a plan to cover the balloon payment?
- Am I comfortable with the risk of not being able to refinance the loan?
- What are my other financing options?
3. What happens if I can’t make the balloon payment?
In the event that you are unable to make the balloon payment, you run the risk of defaulting on the loan, which could result in foreclosure or property repossession. Having a fallback strategy in place is crucial in the event that you are unable to make the payment
The Bottom Line
Balloon loans can be a good option for some borrowers, but it’s crucial to understand the risks involved before taking one out. Carefully consider your financial situation and make sure you have a plan to cover the balloon payment before committing to this type of loan.
Balloon mortgage pros and cons
| Pros | Cons |
|---|---|
|
Affordable: Youll have low initial payments No waiting: You can buy a home sooner if you know youll later have additional income Quick turnaround: You may have a faster processing time than with a traditional lender Less hassle: Youll have fewer documentation requirements Flexibility: You can finance investment properties |
Risk of foreclosure: You could lose the home if you default on the loan Future debt: You may have to take out another loan to cover the balloon payment A longer timeline: Youll build home equity more slowly Tougher requirements: You may have a harder time qualifying Loan costs: Youll have higher interest rates |
How does a balloon mortgage differ from other loans?
A lump-sum payment that is due at the end of the loan term is just one way that balloon mortgages are different from other loan types.
One significant difference is the type of lenders that provide balloon mortgages. Usually provided by small or private lenders, balloon payment loans can be used only for specific kinds of lending, such as construction loans.
Balloon mortgage lenders establish their own requirements. They can be stricter, requiring higher credit scores and down payment amounts.
They may, however, also be more lenient in other respects if the lender serves a clientele that requires alternatives to conventional mortgage requirements. For instance, they might not demand the same quantity of proof of income or let you forego a house appraisal.
Because lenders are taking on a lot of risk, balloon mortgage rates are usually higher than your average 30-year fixed-rate mortgage. In some cases, though, the rates you’re offered may be temporarily lower. You’ll still owe a lot of money if you decide to refinance the loan before the balloon payment is due, and there’s no assurance that mortgage rates will have decreased by then.
Curious where rates are headed? Read our current mortgage rates forecast.