March 31, 2005 in Home Equity

Balloon loan pitfalls

With a traditional mortgage, each monthly payment comprises principal plus interest. In the early years of the loan, most of the payment goes for interest. Gradually, more and more of the monthly payments go toward principal. At the end of the term, the loan is completely repaid. This process of paying principal and interest until the loan is paid off is called amortization.

Some equity debt is not fully amortized. The principal is not paid off at the end of the loan term. This is especially the case with some credit lines. At the end of the loan term, often 15 years, all of the outstanding debt is due in a lump sum. This is called a balloon payment.

If you can’t pay your balloon off at once, you could lose your home. Most people get out of this by refinancing the loan’s outstanding balance into a home equity loan or another line of credit. If rates are high or your credit has gone sour, and you can’t refinance the balloon payment, you could be forced to sell the home to pay off the balloon. Fortunately, this is a rare occasion.

Be careful with loans with balloon features. Steer away from them if you can. If you end up getting a credit line with a balloon payment, don’t let it catch you by surprise.