A balloon mortgage involves small payments for a set period, followed by one large payment at the end of the loan term.
What is a balloon mortgage?
With a balloon mortgage, you make small payments for a set period, and then one large payment. The initial payments may go only towards interest or towards both interest and the borrowed principal, depending on how the mortgage is structured. The balloon payment can amount to thousands or tens of thousands of dollars, typically more than double the monthly payment, according to the Consumer Financial Protection Bureau.
Types of balloon mortgages
Balloon mortgages can be structured in several ways:
Balloon payment:
In this case, the initial monthly payments may be calculated based on a regular 15-year or 30-year amortization schedule, even though the loan term may only be five or seven years. At the end of the term, you will need to pay the remaining balance in one lump sum. In another version of this type of structure, you make payments based on a fixed rate for a period of time, then your rate increases.
Interest-only payments:
In this scenario, you pay only interest for an initial period. Once that period ends, you owe the remaining balance of the loan.
No payments:
In this type, you won’t make any monthly payments for a very short period, but interest will accrue. Once the term ends, both interest and principal will be due in one large payment.
When is the balloon payment due?
According to the terms of your balloon mortgage, the balloon payment is due on the loan’s maturity date. For example, if you take out a balloon mortgage for 10 years, the balloon payment is due once the 10 years are up.
If you are unsure when the balloon payment is due and how much it will be, you can find this information by looking at your mortgage documents.
Advantages and disadvantages of balloon mortgages
Advantages of balloon mortgages:
Low monthly payments or no monthly payments: You may only need to pay interest during the initial period, or have low monthly payments or no payments at all.
Payments can be delayed for several years: Although you will be required to pay the full balance of the loan in one lump sum, you can delay that for several years.
Can buy a home sooner: You can purchase a home sooner thanks to the manageable monthly payments.
Can focus on other goals: If you plan to refinance before the balloon payment is due, you can focus on saving money and building your credit score or achieving other financial goals now.
No penalty for early repayment: There is usually no penalty for early repayment on a balloon mortgage, allowing you to make extra payments or pay it off early without incurring fees.
Disadvantages of balloon mortgages:
Risk to home: Because you will need a large payment when the loan is due, you either need to have enough cash saved, refinance, or sell the home. None of these options is guaranteed, and if you can’t make the payment, you could lose the home and severely damage your credit score.
Deeper debt: To cover the high balloon payment, you may need to take out another loan if you don’t have the cash on hand.
Difficulty finding balloon mortgages: Due to the level of risk, many mortgage lenders do not offer balloon mortgages.
Higher rates: Lenders take on more risk with balloon mortgages, so rates are generally higher compared to traditional loan types.
Difficulty refinancing: If you haven’t made payments (or are only making interest payments), you may not have enough equity in your home to refinance when the balloon mortgage term ends. (Most lenders look for at least 20 percent equity.)
How to
Payment of the Balloon Mortgage
There are four main methods for paying off a balloon mortgage:
Paying Off the Mortgage:
If you can afford it, the simplest – but most expensive – option is to save enough money to pay the remaining balance of the loan in full when it is due. This approach is preferred for those who expect to receive a substantial amount (like an inheritance) or a significant increase in income before the balloon payment is due.
Making Extra Payments:
Paying down the principal of the loan more effectively through 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 or receive a large tax refund, consider directing some funds towards the principal of the mortgage.
Selling Your Home:
If you improve the home and sell it by the time the balloon payment is due, the proceeds from the sale can provide you with enough cash to cover it.
Refinancing:
If you don’t have enough cash to pay the balloon payment, you can check if you qualify for refinancing. To qualify, you will need a sufficient credit score (at least 620), proof of stable income, and at least 20 percent equity in your home. If you don’t have enough equity, you can explore refinancing options with low or no equity. You will also need to consider how the new payment will affect your budget. If you enjoy low monthly payments with the balloon mortgage, refinancing to another loan may significantly increase these payments.
Frequently Asked Questions About Balloon Mortgages
How does a balloon mortgage differ from other loans?
Because they are riskier products, balloon mortgages tend to have higher interest rates compared to traditional fixed or adjustable-rate mortgages. However, they may be lower initially, and you may not have to pay any interest at all in the beginning.
Balloon mortgages also differ from other mortgages in other ways. For example, not all lenders offer balloon mortgages. Often, this type of mortgage can only be found through small or private lenders, as they do not comply with the qualified mortgage principles. Additionally, the eligibility criteria for balloon mortgages may be slightly different from those for traditional mortgages.
Who are the people that balloon mortgages are suitable for?
Balloon mortgages often benefit a certain class of borrowers, including real estate investors and some homeowners – such as those expecting an inheritance or receiving a substantial amount of cash. These individuals typically anticipate a significant increase in their income, plan to sell the property before the balloon payment is due, or expect to be able to settle their debts or obtain funds from other sources.
Should you get a balloon mortgage?
While a balloon mortgage may be suitable for some individuals, like real estate investors, there are also some risks associated with it, including falling behind on the loan if you are unable to make the balloon payment at the end of the loan term. In such cases, the lender would take action to initiate foreclosure on your home. You will also build equity slowly, so you may not realize significant profits when you eventually sell if your loan is still unpaid at that time.
Additionally, if you are relying on selling the home to pay the balloon payment, there is also the risk of a declining real estate market that may prevent you from obtaining a sufficient price to pay the full amount due.
For
For potential borrowers looking to reduce their upfront costs, the Federal Housing Administration’s graduated payment mortgage or the veterans’ mortgage might be a better option. Both are government-backed and include a low or no payment system to reduce initial homeownership costs for borrowers.
Why is a balloon mortgage risky for lenders?
A balloon mortgage poses risks for lenders who heavily rely on the borrower’s ability to make a large lump sum payment at the end of the loan term. If the borrower’s financial situation deteriorates or the property’s value declines, they may struggle to sell or refinance the property to meet the balloon payment and default on the loan. This risk is heightened by the possibility that the borrower is only making interest payments or making minimum payments throughout the loan term.
What are the alternatives to a balloon mortgage?
A traditional mortgage is one alternative to a balloon mortgage, which comes with the option of fixed-rate or adjustable-rate mortgages. A fixed-rate mortgage offers stability with the same monthly payment over the life of the loan. An adjustable-rate mortgage may be suitable for those intending to refinance or sell the home before the initially low interest rate adjusts. For borrowers with low credit scores, government-backed loans from the Federal Housing Administration can provide easier access to financing.
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