Balloon Mortgage Basics: What is it, How it Works, Benefits & Risks


Just the mere mention of the term ‘balloon loan’ brings shivers to many people. It’s not just that it connotes a big sum of money – but the term triggers some scary thoughts.

After all, it might still be fresh in their minds what happened in 2008 when the modern Great Recession began.  Many financial experts are still blaming balloon loans as the primary cause of that housing and financial crisis.  Here, we will discuss what a balloon loan actually is and if the experts are correct to surmise that it can cause a recession.

If you take a balloon loan, the lender will only require you to pay interest for the first few years.  With a traditional loan, you have to pay part of the principal and interest when you make your monthly payment.  So, with a balloon loan, you will only pay whatever interest has accrued on the principal initially and settle the principal later.

Naturally, this will allow you to make smaller payments every month unlike in the case of traditional loans.  Lenders use this balloon structure typically for mortgages although it is not unheard of to have the same structure present in other types of large loans such as auto loans.

Balloon Mortgage Basics

What Is a Balloon Mortgage?

A balloon mortgage is any mortgage where the borrower does not have to fully amortize the loan over its term.  This calls for the borrower to make payments over a length of time (usually five or seven years) and pay off the remaining balance all at once at the end of the term.  That being said, you would expect the final payment to be a large one – hence, they’ve referred to it as a “balloon payment.”

Lenders use a reasonably standard formula to calculate the amortization over a 30-year period but they can use other methods as well such as “interest only.” Some balloon mortgages carry a ‘reset’ option at the end of the term which will automatically recalculate the loan using the current interest rate.  If no such option is present, by default, the lender assumes that the borrower will sell or refinance the home before the end of the term.

Balloon Mortgage – Example

Let’s take a closer look at how it goes about.  Let’s say you get a seven-year balloon mortgage to buy your dream house.  Your lender will give you seven years to pay in equal monthly payments at a fixed interest rate.  This rate would normally be lower compared to what you will get if you went via the traditional mortgage route.  At the end of the seven years, your lender will ask you to pay the rest of the loan.  You can either pay it in full, sell the home, or refinance your loan with the same lender or a different one.

Let’s do that with actual numbers.  Assume that your balloon loan is $200,000 with a term of 5 years and a fixed rate of 4.5% that you will amortize over 30 years.  Remember to note that you will not pay off the loan for the full 30 years but you’ll be making regular payments only for five years.  After paying for five years (or 60 months), you’d still have a balance of $186,213.13.  This is the total lump sum amount that you have to pay your lender at the end of the balloon period.

Balloon Mortgage Versus Other Types of Mortgage

So let’s get to it by looking at numbers to better illustrate how a balloon mortgage stands vis-à-vis other mortgage types.  Let’s assume that you are a buyer who wants to get a loan for $200,000 so you could purchase a home.

Here’s a rundown of the details of the payment you should expect should you want a balloon mortgage, a 30 and 15 year fixed rate home loan or a 5/1 adjustable-rate mortgage.

 

Mortgage TypeAverage Interest RateInitial Monthly PaymentTotal of Monthly PaymentsOutstanding Balance After Loan TermTotal Cost of the Loan
15-year adjustable rate4.55% $1,535.10 $284,8880 $ 284,888
30-year fixed rate5.45% $1,110.00 $399,8180 $ 399,818
5/1 adjustable rate mortgage4.40% $1,001.00 (depends on actual rates)0 (depends on actual rates)
7-year balloon mortgage4.50% $1,013.00 $  85,123 $      186,213 $ 271,336

 

From this chart, you will notice that the mortgage with a balloon payment typically will have a lower interest rate than other types of mortgages.  This means that it will have a lower monthly payment plus, it will spare you the uncertainty of fluctuating rates with an adjustable rate mortgage.  This is why borrowers may qualify for higher loan principals with a balloon mortgage than they would have otherwise with other types of mortgages.

Looking at this scenario, you may say that balloon mortgages could be a good choice for borrowers who are somehow certain that their income would rise accordingly in the near future.  It is also good for borrowers who expect their credit scores to improve significantly in a few years.  Investors who plan to sell the house before the loan term is up also go through this path because the lower interest would provide a bigger income in the end.

Why People Choose Balloon Loans?

There are two main reasons why borrowers prefer balloon mortgages as their preferred financing scheme: the low and fixed interest rate.  Borrowers who want a shorter term compared to other loans also prefer this loan type because it just lasts for 5 to 7 years.  This is also ideal for borrowers who are expecting to receive a windfall or a better income within the next few years.

Another type of borrowers usually benefit from this mortgage:  those who often move from area to area and do not intend to live in their home for the long term.

The Main Benefits of Balloon Mortgages

Budget-Friendly Initial Cash Outlay

Let’s face it:  people will always love the low down payment feature of this loan.  The low initial outlay means that more home loan applicants will become eligible for this financing scheme.  If you are cash-strapped at the moment, you don’t have to kiss your dream of having your own home goodbye.

If you are expecting to get your hands on a huge lump sum in 5 to 7 years, this alternative home financing method could be the answer you are looking for.

Comparatively Low-Interest Rates

Obviously, when you secure a low-interest rate, it would mean lower monthly payments on your loan.  This is particularly advantageous if you are bent on selling the house later because every cent you pay as interest would effectively lessen your profits.

Now, if you plan to live on the house, low monthly payment means more money you can channel to your funds for the balloon payment.  It would also mean that, in case you opt to do it, you will refinance your loan for a much lower amount.

Easier to Qualify For

The fact of the matter is, a great majority would apply for a loan if it were as easy as buying a pair of pants.  The reality is, although there are many loan packages available in the market, qualifying for them is an altogether different thing.

However, it is easier to qualify for balloon mortgages than for traditional mortgages.  For borrowers who are eager to get their first home, this is good news.  And, if you are absolutely confident that soon, there will be a notable upswing in your financial situation (a major job promotion, perhaps) such that you can refinance before the end of the loan, that is even better.

You Can Refinance The Remaining Balance

You may wonder what would happen if you are not able to fully pay your remaining balance at the end of the mortgage term.  Well, you can actually reapply for a resetting or refinancing of whatever loan balance is left during that time.  The catch is, lenders will now use prevailing market interest rates to refinance the balance.

So what’s the problem?  You could face a much higher rate on your refinancing than what you originally enjoyed on your balloon loan.

Balloon Mortgages Risks

So far, everything looks good about a balloon mortgage for many homebuyers in applicable situations.  However, in the financial world, the risk is ever present – and a balloon mortgage has its own refinancing risk too.

Most homebuyers who take a balloon mortgage has the same plan: refinance the mortgage into a more traditional term after the initial period.  However, many things can become obstacles to make that a reality:

  • Interest rates could soar materially from hereon. That would make your monthly payment a lot higher during your refinancing period.
  • The next one might appear as an advantage to many but don’t fall for it: it is going to be a major disadvantage eventually.  Yes, it has a low down payment and most borrowers can get a loan because of that.  The downside is since you’ve only made a small initial outlay, the remaining principal is obviously quite huge.  Therefore, when you compare it with a normal mortgage with a regular down payment, you will end up owing a larger principal amount with a balloon mortgage loan.
  • Five or seven years is a long time and a lot of things can happen. Sure, today you may be a qualified homebuyer but that status is not permanent.  There is always a chance that your income could materially drop, your credit could become worse or interest rates could soar.  Any one of these things could make refinancing extremely hard or financially taxing or maybe even impossible.
  • The real estate market may go downhill (again) and property prices may fall. Picture this:  you’ve already paid off your loan or maybe you’re refinancing it.  All of a sudden, the real estate prices drop.  You will suffer a substantial loss because it would mean you have paid for or are going to pay more than what your property is worth right now.  Worse, you might be left holding an almost worthless real estate.
  • Lastly, property values could plunge while you’re still paying for it. The last time it happened, many balloon mortgage borrowers ended up in foreclosure.  When the initial term of their balloon mortgages ran out, they realized that their homes were worth a lot, lot less than what they owe.  In such a scenario, it was nearly impossible for homebuyers to find a lender who would refinance their mortgages – lenders wouldn’t touch them with a ten-foot pole.

Is a Balloon Mortgage Right For You?

Let’s find out if a balloon mortgage is a good idea in your situation.  If you can answer a definite “Yes!” to the following, it might be for you.  Do you:

  • Know for sure that when the balloon payment comes due, you are no longer staying in that mortgaged property;
  • Expect with a high degree of confidence that you are going to have money at least equivalent to the amount of balloon payment that will come due. It could be from whatever legal source:  a loyalty bonus, annual bonuses, profit-sharing, a maturing investment, an inheritance, or proceeds from the sale of an asset;
  • Believe logically and practically that you will be able to refinance the mortgage before the end of the original term.

What Happens When the Balloon is Due?

Planning ahead is the key to a worry-free balloon loan particularly when the due date comes.  It’s essential that you already have a plan even before you apply for a loan.  But keep an open mind and be flexible since you know that plans don’t always work the way you envision them to.

Many borrowers take any of the following actions:

Refinance Their Loans

One option is to pay off the original loan when the balloon payment becomes due by getting another loan.  Experts call this practice as refinancing. It’s like getting a fresh start on your loan because you will start once again from Day 1 but usually for a longer repayment period.  Some will refinance for another 5 to 7 years while others opt to go for a much longer term of 15 or 30 years.

On the face of it, it looks fairly easy.  However, you need to qualify first for the new loan to make this a reality. This means that even as your balloon payment due date comes near, you should work on improving your income, your assets and most importantly, your credit.

Take note of this:  when you refinance your loan, you are stretching your payment term and you will end up paying more because each additional month means additional interest that you have to pay.

When you refinance, you should hope that interest rates will remain the same as they were (or even lower) than when you first got a loan.  If that is not the case, you lose financially – it would have been more advantageous for you to use a traditional amortizing plan.

Sell the Asset

This is a simple and easy solution.  You can sell whatever you bought with the loan when the balloon payment becomes due.  If you acquired a house or a vehicle, you simply sell it off and use the proceeds to pay the remaining balance.  The important thing is, your asset should be worth enough to cover the loan balance to make this worthwhile.  You might even make a few thousand dollars out of it.

However, you might also lose money like during the time of the housing and mortgage crisis, some homeowners found that their homes were worth far below the amount of their loans.

Pay it Off

If you have the cash, can simply pay whatever balance is left when it becomes due.  This rarely happens because if you had enough money, you wouldn’t have taken a loan in the first place.  Remember that balloon payments can cost tens of thousands of dollars or more.  But, you might be one of the few ones who know for certain that you will have sufficient cash when the time comes.

Sure, it’s good to have a plan for the eventual due date of the loan but you should have a Plan B or Plan C just in case, conditions change somewhere in the middle of your plan.  Weigh the cost and consider the stakes.  You might end up making a sacrifice sale which will drastically affect your credit.

In such case, you’ll feel doubly bad – one for losing money, and another for failing to keep your property.  Another dire consequence is that it may force you to get a recourse loan in which case, you’ll end up paying for something you will no longer benefit from.

What is the Bottom Line?

Looking at the big picture, you can see that balloon loans are way riskier than traditional loans.  If you intend to bring down your housing cost as low as it can get and you’re certain that you can bail out before the balloon payment comes due, this looks like a good option for you.

However, if your financial situation is not very stable or if you’re likely to lose sleep over your chance of getting a refinancing in time, a traditional loan would be your best bet.

When deciding what type of loan to get for your house, you have to consider how you plan to handle the loan and what you intend to do with the house.  If you anticipate that you will get a raise within the next few years such that you can easily qualify for refinancing later, a balloon mortgage should be suitable.

Of course, you have to work on keeping your credit score immaculate until then.  You should talk to your lender or financial advisor to determine which type of mortgage is right for you.  They would often be happy to help you evaluate the pros and cons of a balloon mortgage for your next home acquisition.