What is a balloon mortgage?
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A balloon mortgage comes with major risk for both the borrower and the mortgage lender, but it can be advantageous in some circumstances. If you’ve been offered a balloon mortgage or want to know more, here’s what this kind of loan is all about.
What is a balloon mortgage?
A balloon mortgage is a type of home loan in which you make low or no monthly payments for a short term, usually five or seven years. These initial payments might go solely to interest or to both interest and the loan principal, depending on how the mortgage is structured. After this low- or no-payment period, you make a lump sum payment — known as a balloon payment — for the balance in full. This balloon payment can be thousands or tens of thousands of dollars, and generally more than two times the monthly payment, according to the Consumer Financial Protection Bureau.
Most borrowers won’t need a balloon mortgage, but it can make sense in some situations, especially if you only expect to hold onto the home you’re financing for a short time. This type of loan can be ideal for house flippers, who can use the proceeds from the sale of the home to make the balloon payment.
How does a balloon mortgage work?
With a balloon mortgage, you make small payments for a defined period of time, then one large payment. Most balloon loans require you to pay the balance of the loan as the balloon payment. Let’s consider the following example to examine exactly what a balloon mortgage schedule could look like:
Mortgage amount: $200,000
Mortgage term: 15 years
Interest rate: 4.5%
Monthly payment for 179 months: $1,013.37
Final balloon payment: $133,481.49
Types of balloon mortgages
A balloon mortgage can be structured in several ways:
- Balloon payment – In this case, the initial monthly payments might be calculated based on a typical 15-year or 30-year amortization schedule, even though the loan term might only be for five or seven years. When the term ends, you’d need to pay the remaining balance in one lump sum. In another version of this type of structure, you make payments on a fixed-rate basis for a period of time, then your rate increases. Let’s say you take out a $250,000 balloon mortgage at 3.5 percent, amortized over 30 years and with a loan term of seven years. Using Bankrate’s balloon mortgage calculator, you’d pay roughly $1,123 every month for seven years, after which the remaining $213,734 would come due in one balloon payment.
- Interest-only payments – In this scenario, you only pay interest for an initial period. Once that period’s over, you owe the remaining balance of the loan.
- No payments – For this type, you won’t make any monthly payments for a very short term, but you’ll accrue interest. Once the term’s up, both the interest and principal are due in one large payment.
Pros and cons of a balloon mortgage
- Low or no monthly payments – You might only have to pay interest during the initial period, or make low or no monthly payments at all.
- Can defer payments for years – Although you’ll be required to repay the full balance of the loan in a lump sum payment, you can put this off for several years.
- Can buy a home sooner – You could get into a home sooner thanks to more affordable monthly payments.
- Can focus on other goals – If you plan to refinance before your balloon payment is due, you can focus on saving money, building your credit score or achieving other financial goals now.
- No prepayment penalty – There’s usually no prepayment penalty on a balloon mortgage, so you can make extra payments or pay it off before it matures without incurring a fee.
- Risky – Because you need to make a lump sum payment when the loan comes due, you’ll either need to save enough cash, refinance or sell the home. None of these options are a guarantee, and if you can’t make the payment, you could lose the home and severely damage your credit.
- Hard to find – Due to the level of risk, many mortgage lenders don’t offer balloon loans.
- Higher rates – Lenders take on more risk with a balloon loan, so the rates are typically higher compared to traditional types of loans.
- Difficulty refinancing – If you’re not making payments (or interest-only payments), you might not have enough equity in your home to do a refinance when the balloon mortgage term is up. (Most lenders look for at least 20 percent home equity.)
How are balloon payment mortgages different from traditional mortgages?
Because they are riskier products, balloon mortgages tend to have higher interest rates than traditional fixed- or adjustable-rate mortgages (ARMs). However, the interest rate on a balloon mortgage might be lower than the rates on other options at first, and you might not have to pay interest at all initially.
How do I pay off a balloon mortgage?
There are three primary ways to pay off a balloon mortgage:
- Savings. If you can afford it, the simplest — but priciest — option is to save enough money to pay the remaining balance of the loan in full when the time comes. For this to be viable, you’d need to be saving and investing during the initial period, and possibly even beforehand. This route is best reserved for those who anticipate a windfall (such as an inheritance) or a substantial increase in income before the balloon payment comes due.
- Selling. If you were to make improvements to the home and sell it by the time you need to repay the balance in a lump sum, the proceeds from the sale could provide you with enough cash to make it happen. This is typically the avenue house flippers take, since they don’t plan to keep the property for very long and have a good sense of whether they can sell the home quickly, and for how much.
- Refinancing. If you don’t have enough cash to make the balloon payment, your best option is to refinance — although qualifying for a refinance isn’t a given. You’ll need an adequate credit score (at least 620), proof of steady income and at least 20 percent equity in your home. If you don’t have enough equity, you’ll need to explore low- or no-equity refinance options. You’ll also need to consider how the new payment impacts your budget. If you were enjoying low monthly payments with the balloon mortgage, refinancing to another loan could increase those payments significantly.
Should you get a balloon mortgage?
The low initial payments on a balloon mortgage are enticing — but is this type of mortgage really a good idea? There are a few scenarios when a balloon loan makes sense. First and foremost, this type of loan is best for someone who plans to flip a property. As long as your balloon period is at least a few years, you can be sure you will turn the property over and pay back the loan long before the balloon payment would be due.
This type of loan may also be OK for someone who plans to use the home as a primary residence, but upgrade in five years. You can coincide your move with the balloon payment and use your equity to make the final payment. Finally, a balloon mortgage may also be all right for someone who has a lot of savings but who wants the tax advantages of a mortgage for a few years.
Risks of a balloon mortgage
If you are unable to make your balloon payment, your lender will take steps to foreclose on your home. This is why a balloon loan is considered riskier than a traditional mortgage. You’ll also build equity more slowly, so you may not make a huge windfall when you eventually sell it, if your loan is still unpaid at that time.
For potential homeowners who want to limit their initial costs, an FHA loan or VA loan may be a better option. Both are government backed and require a low or no down payment scheme to reduce upfront home ownership costs for borrowers.
How to get a balloon mortgage?
Since many mortgage lenders don’t offer balloon loans due to the amount of risk involved, finding a lender willing to extend you one could take some legwork, and your options might be limited. If you already have a relationship with a bank or lender, you could start by asking if it offers them, or if it can refer you to another reputable source. There are also other types of mortgages that might work for your situation, so be sure to explore all the options.