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Many people would rather forget the Great Recession that began in 2008 with the collapse of the housing market due to the subprime mortgage crisis. But monumental disasters like this, especially when the economy gets hit really bad, are not easily forgotten.
In fact, people will still remember that under all the rubble, there are thousands of balloon loans gone bad that serve as the villain that started in all. Today, many do not fully understand what a balloon loan is and how a seemingly simple loan could nearly cause the collapse of major economies.
The interesting appeal of balloon loans is that borrowers pay interest for the first few years and make no payment for the principal. It is no wonder why many finance people also call them ‘interest only’ loans. In a traditional loan, you know that your monthly payments will apply for both the interest for the month and partial principal of the loan.
So, you can see that this scheme calls for a much lower monthly payment on the part of the borrower. Normally, you take a balloon loan structure for mortgages but it is not unusual for borrowers to use the scheme for other types of large loans such as auto loans.
Balloon Mortgage Overview
What sets a balloon mortgage apart from other loans is that it does not fully amortize over the life of the loan.
Ideally, the borrower will make payments over a pre-determined period of time (usually five or seven years) then, at the end of that period, pays for the full remaining balance of the loan at once. Obviously, you can surmise that the remaining balance would be huge, hence the term “balloon payment”.
To get the monthly payments on balloon loans, lenders usually divide the loan over a standard 30-year period but some lenders use other computation methods such as interest only. Some balloon mortgages have a “reset” option which takes effect at the end of the loan.
When the borrower requests for a reset, it means that he wants the lender to automatically recalculate the mortgage at the current interest rate. However, when no such option has been provided, it could mean that the buyer will either sell or refinance the home before the end of the term.
Balloon Mortgage – Example #1
Let’s say that a buyer gets a seven-year balloon mortgage to buy a home. The lender will then require him to make equal monthly payments at a fixed interest rate for seven years. Often, the rate will be considerably lower than a traditional mortgage loan.
At the end of the seven years, the lender will ask the borrower to pay the remainder of the balance of the loan. The borrower can either pay it in full or refinance the loan with the lender (or a different lender) or simply sell the house.
Balloon Mortgage – Example #2
Let’s look at what’s going to happen if a borrower takes out a balloon loan for $300,000 with a term of 7 years and an interest rate of 4.5% with an amortization period of 30 years. He will not be paying off the loan for that entire 30 years but will only make payments for seven years. He would then be left with a balance of $262,598 after 84 months of making payment.
This will be the total amount that the borrower will have to pay as a lump-sum payment.
The Pros and Cons of Balloon Mortgages
For borrowers who are looking for low and fixed interest rates on their loans, this is a fitting financing scheme. This is also a type of mortgage that is comparatively shorter than other types of loans because it normally lasts only for 5 to 7 years. A serious word of caution though: expect a huge remaining loan balance at the end of the term that the borrower has to pay in full.
So, if you’re a homebuyer who expects to receive a windfall or is looking to get a higher income within the next few years, this could be for you. Or, if you’re an individual who often relocates or one who is not planning to stay in your newly acquired home for a long time can probably benefit from this kind of mortgage.
Here are the primary benefits as well as risks that normally come with this home financing method:
Balloon Mortgage – Advantages
Affordable Initial Amount
First off, what attracts borrowers to take this type of loan is the low down payment. This feature actually widens the eligibility scope of the loan because more people can now qualify to avail of financing.
So, for borrowers who may be low on cash at the moment but are expecting a huge amount to come in within the next 5 to 7 years, this alternative home financing scheme is very appropriate for them.
It’s pretty obvious that if you get a low-interest loan rate, your monthly payments would also be low. This is especially favorable for a borrower who intends to sell the house later because every cost, including interest, that you sink into the house could potentially reduce the profit.
And if you plan to stay in the house, you would want to minimize the payments so you can save some money for the lump sum when the balloon payment becomes due or to refinance a smaller amount.
Easy To Qualify
When you compare the eligibility requirements between a balloon mortgage and a traditional loan, it’s easier for most people to qualify for the former. This means that many more borrowers will have the chance to get their own home.
This is especially attractive for people who are confident that they can refinance before the end of the term because of an impending upward shift in their financial situation such as an anticipated spike in their regular income.
It is plausible that some borrowers may be unable to pay their remaining balance in full at the end of the mortgage term. In such a case with a balloon mortgage, they can reapply for a resetting or refinancing of their loan balances. There is a catch though: lenders will refinance using the prevailing market rates and not the lower original loan rates.
So, borrowers will have to make higher monthly payments than the ones they used to make on their original loans.
Balloon Mortgage – Disadvantages
Higher Foreclosure Risk
Foreclosure is always a risk regardless of the type of home financing but it is significantly higher in the case of a balloon mortgage. It is easy to see outright where the problems might arise.
First, when the maturity date comes, the lump sum becomes due and the borrower might not have the money to pay for the balance of his loan. Second, when the borrower is not able to qualify for a refinancing. This will make things more difficult and heighten the risk of foreclosure.
In the 2008 mortgage crisis, a material number of borrowers with balloon mortgages went through foreclosure because they were not able to pay for the remaining balance of their loans. Many failed to get refinancing and because of the crisis, it was almost impossible to get a good price for your house let alone be able to sell it.
Easy To Qualify
It’s really tempting for many borrowers to be able to avail of a loan without having to go through a difficult screening process. For those who have no comfortable assurance of being able to afford lump sum payment on the maturity date, this could spell big trouble without them realizing it.
They could find themselves under pressure down the road to sell at a loss or letting go of their home due to foreclosure. Of course, they might get lucky and sell it at a gain but that is essentially wishful thinking. Perhaps it’s an effective way to learn a valuable lesson or two in prudence and planning – but they still have to deal with the fact that they’ve lost their home because of their own undoing.
Huge Payment at Once
This is probably the most compelling reason why you should not just jump right in and get a balloon loan: you will have to make a substantial payment at maturity. So, if you really want this type of mortgage, you have to be absolutely certain that by the end of the term, you will have enough money to pay off the balance – otherwise, you’ll be setting yourself up for a disaster.
Just remember that a typical family with an average income may find it nearly impossible to raise that kind of money within 5 to 7 years to sufficiently cover the balloon payment.
From all angles, balloon loans are undoubtedly a whole lot riskier than traditional loans. If your primary aim is to bring down your housing costs as low as you possibly can and you are confident that you can get out before the balloon payment becomes due, then you can go for it. However, if your financial situation is a bit shaky and you’re the type of person who would worry to death that you won’t be able to refinance or sell in time, think twice and hard. You may be better off going for a traditional loan.
Planning how to purchase your house should depend on what you plan on doing with it and how you intend to pay off the loan. If you are certain that you are going to get a raise within the next couple of years and can refinance without a problem, those are plus factors. All you need to do next is keep an immaculate credit score until then. If you meet these conditions, then a balloon mortgage is a great option.
Thoroughly evaluate your circumstances now, your financial situation, and your future income potential before you make a decision.
You may ask your lender for help in picking the right mortgage for you. They will be more than happy to go through the pros and cons of a balloon mortgage with you so you can make a highly informed decision.