A balloon loan is a mortgage loan that requires a larger than usual one-time payment at the end of the term. This means your payments are lower in the years before the balloon payment is due. The problem with a balloon loan is that at the end of the term, you may be required to pay tens of thousands of dollars to pay off the remaining balance in full. Keeping that in mind, you have to make sure you will be prepared to make this very large payment at the end of the term of the loan.
How Does a Balloon Loan Work?
Interest rates on balloon loans may be either fixed or adjustable. You can also have interest-only loans. Nonetheless, the interest rate is lower and therefore payments smaller, since the bank will not have to service the loan for the full 30 years and get its money back in say 7 to 10 years instead. Another reason the payments may be lower is that the principal is only partly paid monthly since there will be a big balance due at the end of the term.
To illustrate, compare a 7-year balloon loan of $100,000 at 6 percent interest and a 30-year traditional home loan of the same amount at 7 percent interest. With the balloon loan, you could make a monthly payment of only $520 and at the end of seven years, there will be a balance of $46,000 remaining in the principal amount, which you must pay in full. In contrast, for the traditional home mortgage loan, the monthly amortization is $665 for the next thirty years after which, the loan balance will be zero.
What if You Can’t Pay the Balloon Payment?
The majority of borrowers are not likely to meet the required balloon payment at maturity, so balloon loans usually carry the reset option where the borrower can seek refinancing for their home. The new loan can also be another balloon loan or a traditional home mortgage loan with a longer-term.
The lender may recommend or the borrower may choose the type of loan to be availed of for the refinancing, depending on the borrower’s ability to repay the loan and his overall financial situation by then. As can be expected, the borrower chooses the type that charges the cheapest interest with the least monthly payment over the shortest period of repayment.
ARMs vs. Balloon Loans
Do not be confused with a balloon loan and an adjustable-rate mortgage (ARM) loan. Ballon loans deal with the manner of repayment and that your final payment is for one big amount. The classification of an ARM loan is based on how the interest is charged. ARM loans are usually availed of under the more conventional home mortgage loans. With adjustable-rate mortgage loans, your initial interest is typically low but the rate is adjusted each year or two depending on the terms of your loan. When the interest on your loan is adjusted, your monthly payments also change as a result of the adjustment.
You are at an advantage with an ARM loan when the interest rate goes down. We are in one of those rare times when the mortgage rate is going down, definitely not the normal case. On the other hand, the advantage of a balloon loan is the flexibility to shop for a better rate when the time comes the loan has to be refinanced. While you may not be able to control the fluctuations of interest rates under ARM loans, there is no need for refinancing. This convenience is what attracts many borrowers to the ARM loan product.
Balloon loans grew in popularity during the last surge in the housing market around 2006. Many home buyers sought 15-year balloon loans secured by second mortgages to pay for the down payment of their homes. This helped them avoid having to buy mortgage insurance. If you are in the market for a new house or a new loan, you may want to learn more about balloon loans. It might just be the type of loan you need.
Is a Balloon Loan Right for You?
If you are planning on moving within the next 5 to 7 years, a balloon mortgage might be right for you, since you will be selling the home and closing out the loan at this time. Studies show most 30 year loans never make it to maturity but are refinanced or paid off. If you are not planning on moving before your loan matures, you may be caught in a situation where your loan matures, but interest rates are high at the time of refinancing, you may find yourself in a mortgage with a crippling interest rate.