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. After this low- or no-payment period ends, you pay a lump sum, which settles the remaining balance in full. Because they don’t require much outlay right away, balloon mortgages can be tempting — but they can easily explode on you. Here’s what this kind of loan is all about, from the risks to the rewards.

How does a balloon mortgage work?

With a balloon mortgage, you make small payments for a defined period of time, then one large balloon payment. The initial payments might go solely to interest or to both interest and the loan principal, depending on how the mortgage is structured. The large 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 balloon loans require you to pay the balance of the loan as the balloon payment.

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..

• 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.

When is the balloon payment due?

Under the terms of a balloon mortgage, the balloon payment is due on the loan’s maturity date. For instance, if you take out a 10-year balloon mortgage, the balloon payment is due once the 10 years have elapsed.

“At the end of the loan term, the remaining balance is due,” says Jack Kammer, vice president of mortgage lending for the mortgage company OriginPoint. “The borrower has paid off only a fraction of the principal balance by the end of the loan term because the repayment is calculated as if it was a traditional 30-year mortgage,”

If you’re uncertain about when your balloon payment is due and how much it will be, you can find this information by looking at your mortgage note. “The mortgage note is usually a three- to five-page document that discusses the terms of the loan in legal jargon. It will have a ‘due date’ section or a ‘term’ section that specifies this information,” says Mason Whitehead, Dallas, Texas-based manager for Churchill Mortgage.

Pros and cons of a balloon mortgage

Pros

• 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.

Cons

• Risk to home – 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 guaranteed, and if you can’t make the payment, you could lose the home and severely damage your credit.
• Deeper debt— In order to cover the steep cost of the balloon payment, you may need to obtain another loan if you don’t have the cash set aside.
• 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 other loans?

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.

Balloon mortgages differ from other mortgages in other ways as well. For instance, not all lenders offer balloon mortgages. Often, these types of mortgages can only be found through small lenders or private lenders, as they don’t conform with qualified mortgage guidelines. Additionally, the eligibility criteria for balloon mortgages may be slightly different than a traditional mortgage. And finally, because there’s substantial risk associated with balloon mortgages, the interest rate is likely to be higher.

Ways to pay off a balloon mortgage

There are three primary ways to pay off a balloon mortgage:

• Pay off the mortgage. 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.
• Make extra payments. Paying down your loan principal more aggressively with extra payments during the initial period reduces the remaining balance due at the end of the loan term. If you have extra income each month, consider making a second payment. Alternatively, if you come into money during the course of the year or through a large tax return, consider directing some of the funds to your mortgage principal.
• Sell your home. 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. 
• Refinance. 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.

There are also some risks associated with balloon mortgages, including defaulting on the loan if you’re unable to make the balloon payment at the end of the loan term. In such cases, your lender will likely take steps to foreclose on your home. 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.

In addition, if you’re counting on selling the home in order to make the balloon payment, there’s also the risk of a real estate market downturn that leaves you unable to fetch a high enough price to pay the full amount due.

For potential homeowners who want to limit their initial costs, an FHA graduated payment loan or VA loan may be a better option. Both are government backed and include a low or no down payment scheme to reduce upfront home ownership costs for borrowers.

Bottom line on balloon mortgages

Balloon mortgages are best suited for real estate investors who plan to flip the home and use the proceeds to make the balloon payment. Beyond that, if you intend to use the home as your primary residence, a balloon payment may make sense if you already have the money set aside in investments or savings to make the final payment or you’re expecting to come into a large sum of money prior to the balloon payment date, such as through an inheritance.

If you’re simply looking for a lower monthly mortgage payment, remember there are risks with balloon mortgages. If you’re unable to make the balloon payment, you face default and foreclosure. Rather than putting your home on the line, consider alternative mortgage options. ARMs offer lower interest rates and mortgage payments for an initial period. And even when the interest rate on an ARM changes at the end of the introductory period, the entire loan balance is not due like a balloon mortgage. FHA graduated payment mortgages and VA mortgages are also options to keep in mind.