What Is a Balloon Mortgage?
Mortgages are necessary for most people looking to buy a home. With so many options available, it isn't unreasonable to be confused while looking for the right loan, especially if you’re a first-time homebuyer. Those wondering what a balloon mortgage is will find it differs from your traditional loan type but can work well in some situations.
Knowing the ins and outs of balloon mortgages will help you make smart financial decisions as you close in on a home purchase.
What is a balloon payment on a mortgage?
Mortgages come in all shapes and sizes, including conventional and adjustable-rate mortgages. While these are common choices for homebuyers, one option to consider is the balloon loan. After all, learning how to buy your first home often begins with comparing mortgage loan options.
A balloon mortgage is unique because you don't make regular principal payments over the loan's term. Instead, the payments generally cover only the interest (but may also cover a small portion of the principal balance). At the end of the term, you'll still owe all or most of the principal and must repay it in a lump sum. A traditional loan, on the other hand, amortizes over the loan’s full term, resulting in monthly payments that cover both principal and interest.
Suppose you borrow $350,000 to buy a house with a five-year balloon mortgage. If you only pay off the interest throughout the loan, you'll still owe $350,000 (or close to it) at the end of the five years. This amount is your balloon payment.
You can use a five-year balloon mortgage calculator to see the balance you would owe if you only make interest payments during the five years. You can also compare all the different loan options, including balloon loans, by looking for the best mortgage lenders.
How does a balloon mortgage work?
A balloon payment mortgage is considered a short-term loan. The primary difference between conventional mortgages and balloon loans, aside from the final lump sum payment, is the way you repay them.
The first of the repayment terms is the interest rate. As with all mortgages, your balloon loan accrues interest. Most balloon loan lenders require paying the accrued interest monthly. Some loans may also require paying some of the principal balance monthly, though this may vary on a case-by-case basis.
The next repayment term is the duration. While a traditional loan lasts 20 to 30 years, balloon loans generally last approximately five years, although some can have seven-year terms. The unique aspect of a balloon loan is that you'll owe a large amount of money at the loan's maturity, which the lender states upfront.
If you take a five-year balloon loan, you only get five years to repay the loan. Your lender will require paying the interest that accrues during this time but not necessarily any principal. The result is that you'll owe the full principal balance all at once at the end of the five years. So the balloon payment refers to a large sum (or "lump sum") of money you owe at the end of the loan.
Lenders generally offer lower interest rates for shorter-term loans, allowing you to potentially pay less interest with a balloon loan. However, lenders use numerous factors when assigning an interest rate, including your credit score and down payment.
Balloon mortgage pros and cons
- Lower monthly payments
- Flexibility for short-term home ownership
- Potential access to larger loan amounts
- Easier to qualify for
- Making a large payment at the end of the loan term
- Risk of foreclosure
- The risk of rising interest rates
- The risk of declining property value
Pros explained
Lower monthly payments
One of the most significant benefits of balloon loans is their low monthly payments. Lenders generally only require you to pay the accrued monthly interest each month, while traditional loans require paying principal and interest. Your monthly payment will be lower until the balloon payment is due.
Flexibility for short-term home ownership
Balloon loans make sense when you plan to sell within a few years and need low payments in the meantime. You'll have low costs during the few years you live there, then use the proceeds from the home sale to pay the balloon loan in full when it's due. This could be a good option if you plan to remodel and sell the house, for example. It also works well if you expect a large inheritance or windfall within the next few years. You could use the money to repay the loan principal when due.
Many lenders also let you pay toward the principal balance during the term, allowing you to reduce your balloon payment at the end. Check with your lender to see if the loan has a prepayment penalty, as lenders can include these clauses. If it doesn't, you can repay the loan early in full or partially. Unfortunately, if your lender doesn’t allow prepayments, paying toward the principal balance before it's due might result in significant penalties.
Potential access to larger loan amounts
Due to its low payments, a balloon loan lets you borrow more than you could with a traditional loan. You could be able to afford a larger, more expensive home as a result. This option works well if you're expecting to sell or earn significantly more money in the future.
Easier to qualify for
Because of the short repayment period and the low monthly payments, balloon mortgages are considered low-risk loans. Because of the lower risk, lenders are more likely to approve borrowers who would normally not qualify for a longer term mortgage.
Cons explained
Making a large payment at the end of the loan term
The primary downside of a balloon loan is you'll owe a large balance at the end of the term. It's best to plan how to repay it before borrowing with this type of loan. A balloon mortgage calculator helps provide an estimate of your monthly payments as well as your ending balance
Risk of foreclosure
If you can't repay the principal balance of your balloon mortgage by its due date, you risk losing the home to foreclosure. A lender can foreclose on the property if you default, potentially devastating your finances. It's important to have a plan to pay the lump sum by its due date.
The risk of rising interest rates
You could borrow money through a short-term balloon loan while intending to refinance before its due date. Unfortunately, you risk having a higher interest rate when you refinance, as interest rates fluctuate. If rates are low now, getting a conventional loan might be a better option if you plan on keeping the home for longer than the life of a balloon loan.
The risk of declining property value
There is also a potential risk for home value loss when you refinance your balloon loan at the end of its term. If home values drop during the loan’s term, the decline in your property value could result in challenges in getting a new mortgage to cover the full balance you owe.
Can you refinance a balloon mortgage?
Your balloon loan has a set due date for making the lump sum payment to avoid foreclosure. The good news is you have options if you can't afford to pay the loan off when it comes due.
One option is to refinance. When you refinance, you apply for a new loan. You can choose a traditional mortgage or refinance with another balloon loan if you qualify. Before refinancing, look at the current balloon mortgage interest rates. Compare those to interest rates on other loan types to determine the best plan for your situation.
How to get out of a balloon mortgage
A balloon mortgage is not a traditional mortgage, but it works well in some cases. However, balloon loans eventually mature. You have several options to avoid making the lump sum payment.
1. Refinance your balloon mortgage
Refinancing a balloon mortgage is one option if you can't afford to pay the balance. If you qualify, you can refinance into another balloon loan or a more traditional loan. The proceeds from the new loan pay off your balloon mortgage, ensuring you satisfy that loan.
One thing to note is that refinancing is not guaranteed. To refinance, you must meet the lender's criteria for loan approvals. Most lenders consider a person's credit score and debt-to-income (DTI) ratio when evaluating loan applications. Lenders also base loan decisions on home values and home equity. When reviewing loan applications, they carefully consider a home's loan-to-value (LTV) ratio.
2. Dedicate a savings account for your lump sum payment
Develop a plan for repaying the loan when you initially take it. One way to do this is by setting aside a monthly sum in a dedicated savings account. Divide the loan by the number of months to determine how much to save each month. Unfortunately, this isn't always a feasible option. You'll generally have to save a considerable amount each month in order to pay the loan off in only five or seven years.
If you already have enough cash to repay the loan, you could keep the cash in an investment account during this time. Compare the money you'll make from the investment to the loan's interest. It's a smart move if you can make more money investing the money than you'll pay in accrued interest. But be careful: investments can lose value and leave you with a shortfall when it’s time to make the balloon payment.
3. Negotiate with your mortgage lender
Another option is to talk to your mortgage lender before the due date. You should start the conversation a few months before it's due. Ask your lender if you can renegotiate your balloon mortgage terms. If the lender is willing, it might give you a few more years to pay off the money you owe.
4. Consider selling the property
If you sell the property, the proceeds will first pay off the loan, then generally your realtor's commission and other closing costs. You can talk to a realtor to learn more about the closing costs typically owed when selling. Any money left after paying expenses and the loan balance is yours to keep. Selling a house offers a simple way to satisfy a balloon loan lump sum.
Is a balloon mortgage a good idea?
Balloon loans are mortgages that help you buy a house without obligating yourself to a hefty monthly payment. While they're good in some situations, they shouldn't be your immediate go-to option. They are great if you need a short-term loan or want lower payments for a few years.
As with any loan, look at the current balloon mortgage rates and examine a balloon mortgage amortization schedule before choosing this option. This schedule shows what to expect for monthly, interest, and balloon payments.
If you choose a balloon loan, have a clear repayment path for its due date. Consider looking for a different loan type if you can't figure out how to pay for it beforehand.
Summary of Money's What is a balloon mortgage?
A balloon mortgage is one of many loan types you can get to buy a home. Balloon loans are short-term loans that provide the benefit of low monthly payments. They're ideal for people who need short-term solutions or access to more expensive homes without having sizable monthly mortgage payments.
But taking a balloon loan requires some planning because of the large lump-sum payments at the end of the loan. Before taking one, you should consider the risks associated with balloon loans, which include declining property values and potential foreclosure. Balloon loans are ideal for some situations but might not be the best loan type for your specific needs.