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What is a Balloon Mortgage?

Nicki & Karen » October 10, 2022

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balloon mortgage

If you’re thinking of buying a home, you’re likely considering all of the loan options at your disposal. There are several different types of mortgages you can select from, which include everything from a conventional mortgage to a balloon mortgage. While balloon mortgages can be risky, they offer numerous advantages that may give you the help you need to purchase your own home.

Balloon mortgages are real estate loans that come with an initial payment period where the monthly payments are low or non-existent. Once this period of time comes to an end, the entire balance of the loan will need to be repaid in full. If this is the only solution available to you when purchasing a home, it may allow you to go forward with the transaction.

Because of the potential risks associated with this mortgage, it’s highly recommended that you do your due diligence before selecting a balloon mortgage for your home-buying needs. This guide provides you with a more comprehensive overview of balloon mortgages and when they should be considered.

mortgage signing

What is the Definition of Balloon Mortgage?

A balloon mortgage is one that begins with low and fixed payments over a set period of time. The main difference between balloon mortgages and conventional mortgages is that you’ll be required to repay the remainder of the loan as a lump-sum payment once the initial repayment period comes to an end. In comparison, conventional mortgages allow you to make set monthly payments until the entire loan has been repaid.

The reason that this mortgage is referred to as a balloon mortgage is because the one-time payment that occurs at the end of the repayment period is considerably larger than the initial payments. It’s possible for balloon payments to be tens of thousands of dollars.

How Does a Balloon Mortgage Work?

While all balloon mortgages function in the same manner, the exact terms of the mortgage depend on the specific loan and lender. In most cases, these mortgages will come with fixed payments that last for a set period of time before the balloon payment is due. The initial balloon mortgage payments are typically small since they aren’t wholly amortized. Keep in mind that amortization involves repaying a loan with monthly payments that reduce the overall balance and allow the loan to be fully repaid over time.

When looking specifically at balloon mortgages, the initial payments might only involve interest as opposed to the principal of the loan. When a mortgage loan has been fully amortized, the monthly payments you make will reduce the interest and principal of the loan, which results in the entire loan being repaid by the conclusion of the repayment term.

In comparison, balloon payment amortization is only partial, which means that the initial payments you make won’t cover all of the interest and principal. Once you make the balloon payments, your entire mortgage loan will be paid off. Even though the length of a balloon loan term can differ, most of these mortgages come with 5-10 year terms.

open house mortgage

Why Get a Balloon Mortgage?

There are numerous reasons why a balloon mortgage may be the right option for you. If you believe that you’ll only be living in the home for a relatively short period of time, you should consider opting for a balloon mortgage. You’ll benefit from lower monthly payments as well as reduced costs since the loan is paid off in 5-10 years as opposed to 20-30 years.

If you believe that you’ll be remaining in the home but refinancing before the final balloon payment is due, you can take advantage of this solution without experiencing many of the downsides. Keep in mind, however, that your monthly payment will increase once you decide to refinance the original balloon mortgage.

This type of mortgage is also advantageous for buyers who receive a large portion of their income as a year-end bonus. In the event that you’re certain to receive this income, you may be able to purchase the home at an earlier date.

A Balloon Payment Schedule Example

To understand what a balloon payment schedule is like, let’s take a look at two examples. One of these mortgages involves interest-only monthly payments. The other example involves interest and principal payments. The initial mortgage has a five-year term and interest-only payments. When taking a look at this example, the principal amount of the loan would be $200,000 with an interest rate of 5%.

In this scenario, the $200,000 principal of your loan won’t decrease during the entire five-year term. You will, however, have a monthly payment of just over $833 that remains the same until the loan is over. At the conclusion of the repayment term, you’ll be tasked with providing a balloon payment of $200,000.

As for the second example, it involves a 10-year balloon mortgage that consists of interest and principal payments. With the same $200,000 principal amount mentioned previously and an interest rate of 5%, the monthly payments would be based on an amortization of 30 years, which means that the monthly payments would be substantially lower than they would be when taking out a 10-year loan that’s been fully amortized.

Since the balloon payments are calculated with 30-year amortization, you won’t have paid off the loan by the end of the 10-year term. In this scenario, your monthly payments would amount to just under $1,074 per month. Once the 10-year repayment term has come to a conclusion, the balloon payment will be around $162,683.

balloon mortgage payment

What are the Risks of Balloon Mortgages?

While there are many benefits of balloon mortgages, there are also numerous risks that you should take into account before sending in your application. As the homeowner, you’ll have very little equity in the home even after the initial repayment period is over. If the local real estate market has slowed or is in decline, you might not receive any profits when it comes time to sell the home.

If the local real estate market drops substantially, you could find yourself in a bad situation. In the worst scenario, your lender might not agree to lengthen the repayment deadline for your balloon payment. Keep in mind that defaulting on this type of mortgage is serious and can result in your credit score being heavily damaged and your home being foreclosed on.

Even though it’s possible to refinance a balloon mortgage, it’s oftentimes difficult to be approved for a refinance. Since the borrower doesn’t have much equity in the property, lenders may view them as being less creditworthy. Even if you don’t care about the risks associated with a balloon mortgage, there are also several risks for lenders. Since the final payment is large, it’s more likely that the borrower will default on the loan.

How to Pay Off a Balloon Loan

There are several methods you can use to pay off a balloon mortgage, all of which you should be aware of before applying for this mortgage.

Settle It

Your first option is to settle the mortgage, which involves paying all of the remaining principle if you can afford it. Immediately after taking out this loan, you should be saving and investing as much as possible.

Refinance It

Another option is to refinance the loan, which involves paying off the balloon mortgage by taking out a conventional mortgage that’s properly amortized. This strategy is ideal if you have a moderate amount of equity build up in the home or have a consistent income.

Sell the Home

The third option is to sell your home, after which your proceeds could be used to repay the debt you owe. This is a great option for anyone who was only intending to live in the home for several years. It’s common for house flippers to use this option.

The Pros and Cons of Balloon Mortgages

Balloon mortgages aren’t for everyone, which is why it’s important for you to weigh the pros and cons before making a final decision.

pros and cons balloon mortgage

The Pros of Balloon Mortgages

The main benefits of a balloon mortgages include:

  • Low initial payments – Your monthly payments throughout the initial fixed period will be smaller than they would be with a fully amortized loan.
  • A home can be bought sooner – Paying the large balloon payment at the end of the initial repayment term allows you to fully own a home in just 5-10 years.
  • Quick loan processing time – Most lenders are able to underwrite these loans at a much faster pace than conventional mortgages.
  • Beneficial for house flipping – This type of mortgage gives you the opportunity to fix the home and flip it for a higher profit before the full loan term is up.
  • Less documentation requirements – These mortgages don’t always require home appraisals and other forms of documentation.

The Cons of Balloon Mortgages

There are also some notable issues with this type of mortgage, which include:

  • May lose your home – These mortgages are risky unless you’re confident you can make the balloon payment at the end of the term.
  • Might need to borrow money – If you can’t make the final payment, you might need to take out an additional loan.
  • Equity is built at a slower rate – Your monthly payments won’t pay off much of the principal, which means that you won’t build much equity.
  • High qualification requirements – More risk for the lender means that qualification requirements are higher.
  • High interest rates – This type of mortgage usually comes with high interest rates when compared to conventional mortgages.

Should You Take Out a Balloon Mortgage?

There are times when taking out a balloon mortgage is a preferable solution compared to the alternatives. If you’re already able to afford the final balloon payment, you won’t be taking on much risk when you apply for this loan. In the event that you’re anticipating receiving a large bonus or inheritance before the mortgage is due, this option could be perfect for your situation. The same is true if you expect to receive a sizable increase in income.

There are also some investors who only want short-term financing because they intend to fix and flip the home for a profit. If you’re considering flipping houses, the balloon mortgage should be a heavy consideration. Another reason to consider this type of mortgage is if you only expect to live in the home for a few years before selling it.

Despite their inherent risk, balloon mortgages provide many potential buyers with a great opportunity to own a home. Before sending in an application, it’s highly recommended that you identify the current state of your financials, which should give you a better idea if a balloon mortgage is right for your situation.

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