A balloon mortgage is a loan with a short payoff date, usually five or seven years, but the monthly loan payment is calculated on a longer term, usually 15 or 30-years.
The loan is said to balloon after the five- or seven-year term; the entire loan amount is required to be paid off in full. This is known as a balloon payment.
With a 15- or 30-year fixed-rate mortgage the loan amount is paid back to the lender over a 15- or 30-year time period with interest. The monthly balloon mortgage payment is calculated in the same way as a 30-year fixed-rate mortgage, in most balloon mortgage plans. If the interest rate and loan amount are the same, the monthly loan payment will be the same. The difference of course is that after five or seven years, the entire balance must be paid off.
So why would anybody want a balloon mortgage?
The primary reason home buyers and homeowners take a balloon mortgage is because the interest rate is lower than a 30-year (or 15-year) interest rate. The lender is happy to offer a lower interest rate to borrowers who take out a balloon mortgage because the bulk of the loan will be paid off in its entirety within a few years.
The lower interest rate can enable a home buyer to purchase a more expensive home or give the home buyer a lower mortgage payment than a 30-year fixed-rate.
How do I pay off the balloon mortgage?
You might be thinking, so how does anybody come up with the money to pay the balloon payment?
Simple. The balloon mortgage can be refinanced up to the balloon date.
I know of a lender who pushed (encouraged) home buyers into balloon mortgages. The home buyers were able to finance more money and consequently, purchase more expensive homes. This tactic is beneficial when there is competition for homes.
With some situations, it could be the only way to snag the ideal house. After one or two years, the lender went back to the borrower to refinance the home buyers into a 30 or 15-year mortgage. The balloon balance was paid off under the refinance.
Balloon mortgages can make sense
Balloon mortgages are ideal for a corporate transferee. If the borrower knows that he or she is going to be transferred within a few years, a balloon mortgage makes sense.
Why not take a balloon mortgage on a house with a lower interest rate with the understanding that the home will be sold and the mortgage will be paid off before the loan is required to be paid off?
Borrowers who have an expectation of an inheritance or know a chunk of money is coming their way can benefit from a balloon mortgage.
Balloon mortgage reset option
Chances are, the balloon mortgage will have a rest option (make sure the lender includes this option).
The balloon mortgage reset option means that the balloon mortgage will convert to a fixed-rate mortgage for the remainder of the amortization period. The interest rate on the balloon mortgage will be adjusted.
Read the fine print. It's possible that the new interest rate could be higher than the current market interest rate. Other conditions for the reset are required for a reset.
Alternative to a balloon mortgage
For home buyers and homeowners who are uncomfortable with the thought of a balloon payment, then a hybrid mortgage would make sense.
The hybrid loan is a combination of a fixed-rate for a term of five or seven years and then converts to an adjustable interest rate. The benefit of course is that there is not the final payment with the hybrid mortgage. The interest rate on a hybrid mortgage is usually lower than the fixed-rate mortgage terms but higher than a balloon mortgage.
Frequently Asked Questions About Balloon Mortgages
Can I sell my home with a balloon mortgage?
Homeowners are permitted to sell their house with a balloon mortgage. The only caveat is that the sales price less expenses are sufficient to pay off the balloon loan.
Can you refinance a balloon mortgage?
You will be able to refinance the balloon mortgage, provided you meet the customary refinance guidelines, such as debt to income ratios, income, and credit requirements.
What happens when a balloon payment comes due?
There can be different scenarios when the balloon is about to burst. Dig through your mortgage papers and carefully read your payment options.
You might find that the loan will convert to a fixed-rate loan, or possibly an adjustable-rate loan. But if there is no benign way to extend the balloon mortgage, call the lender and ask for a modification.
If you are unable to modify the loan, ask the lender if you can refinance the mortgage. If you're unable to modify the loan or refinance, the only option available is to sell the house.
What is a balloon payment on a mortgage loan?
The balloon mortgage is similar to a fixed-rate mortgage during the initial loan term. The lender accepts the loan payment each month and pays the loan interest and reduces the principal balance, but after a predetermined time period (i.e. five, seven, or ten years), the loan is said to balloon. The loan balance is expected to be paid in full.