Mortgages come in many different varieties and if your situation is unusual, you may be best served by an unusual type of mortgage.
One of these lesser-used mortgage types is known as a balloon mortgage, also referred to as a balloon payment mortgage.
In this article, we’ll discuss what it is and how it’s different, when you might use it, and its benefits and drawbacks.
What Is a Balloon Mortgage?
When you purchase a home with a balloon mortgage, you will begin making monthly payments for an amount that is similar to a standard 30-year fixed mortgage at the same rate.
However, after a period of time – usually five to seven years – you will stop making regular monthly payments and instead will be required to pay off the entire loan balance. A balloon mortgage is essentially a short-term loan that is set up like a long-term loan for the first few years.
How a Balloon Mortgage Is Different
A standard mortgage, such as a 30-year fixed rate mortgage, is set up such that when you satisfy all the payments over the life of the loan, you will completely pay it off and owe nothing at the end. The process of spreading out your payments is referred to as “amortization.” If payments are set up to cover the full balance over the life of the loan, it’s known as a “fully amortized” loan.
A balloon payment mortgage is very different because while the loan will have a defined length and you’ll make regular monthly payments, those payments will not be sufficient to pay off the balance by the end of the loan’s term. This leaves a “balloon payment,” or a very large amount due, at the end of the mortgage. Often, the “balloon payment” is almost as large as the original loan amount, depending on the term of the mortgage.
Unless the borrower has come into a windfall of money, most people can’t afford the balloon payment and will refinance the loan at that time. If the mortgage has a reset option, the borrower may opt to let it reset and continue the mortgage with a new payment and new loan term. But if you can’t refinance, use a reset option, or pay off the balloon payment, your home will go into foreclosure.
Some balloon mortgages have a “reset” provision, whereby the loan converts to a fully-amortized mortgage and the lender automatically recalculates mortgage payments based on a predetermined loan term. This is essentially a mortgage refinance, but the terms may not be as favorable were the borrower to seek or qualify for a refinance at current rates.
Balloon mortgages with a reset provision are sometimes known as “convertible” balloon mortgages. They’re often written in shorthand to demonstrate how long you have before the reset occurs. For instance, a 3/27 convertible balloon mortgage will have three years of payments at the original interest rate. Then, if a balloon payment isn’t made in year four, the loan will convert to a fixed-rate fully amortized 27 year mortgage. The new interest rate is often determined according to prevailing interest rates and may or may not be as good as the rate on a refinance.
Why Get a Balloon Mortgage?
Many people avoid these mortgages because they seem complicated and downright scary. They do often have lower interest rates and are used by people who don’t intend to own their property for very long, such as investors or those who move frequently.
- Lower interest rates than standard 30-year fixed rate mortgages
- Often easier to qualify for
- Lower closing costs
- Can reset to a standard, fully-amortized mortgage (if convertible)
- Must refinance or come up with a large amount of cash to pay off the loan at the end of the term (if not convertible, or no reset option)
- Not every lender offers them
- Reset option may not be as favorable as refinancing
- Risk that interest rates will increase between loan origination and the time to refinance
Balloon mortgages were once used only by investors, but are now available for homeowners as well. While they can be a great tool, they do have drawbacks and aren’t right for everyone. For example, you may not want to use a balloon mortgage simply to get a lower rate if you plan to retire in your new home – that is, unless you’re prepared to refinance in a few years and are willing to be at the mercy of prevailing interest rates at that time. As with any mortgage, make sure you understand how a balloon mortgage works and that it suits your situation and goals before you sign on the dotted line.
Have you ever considered getting a balloon mortgage for your home? Why or why not?