In this article, you will learn what are the advantages and disadvantages of a balloon mortgage. This article is part of a series ‘All About Mortgages’ that answers questions for those who seek out a general knowledge on the subject matter.
Most balloon mortgages during the 1920s were interest-only loans, where the borrower paid no principal. When the loan came to maturity, about 5 or 10 years, the loan that had to be repaid became equal to the original loan amount. In today’s market, balloons are calculated on a 30-year amortization schedule, which allows for some principal reduction.
What is a balloon mortgage?
In short, a balloon mortgage is a loan that is “payable in full after a period that is shorter than the term.” Distinctively known for its negative amortization and short loan duration, a balloon mortgage is quite different from other types of traditional mortgages. It has small fixed monthly payments and shares most characteristics with a 30-year fixed-rate mortgage. The loan can be calculated based on a thirty-year period. The most notable feature of this loan is that you must make a large payment in the end to cover the outstanding principal. Unlike a fixed mortgage where your loan will be paid once the term comes to an end. In this loan, the final principal amount that you pay can be 1.5-2 times more than the monthly payments that you’ve previously made.
Resource – Mortgages For Dummies
Comparing an Adjustable-Rate Mortgage and a Balloon Mortgage
Understanding the balloon mortgage is useful to compare it with an adjustable-rate mortgage. Both the adjustable-rate mortgage and balloon mortgage offer a fixed rate in the early years, and both obtain an increased risk in the later years. However, there are a few key differences.
- Adjustable-rate mortgages substantially increase its rate after the 5- or 7-year period and are greater than the balloon.
- Borrowers may have trouble refinancing their balloon mortgage if interest rates significantly increased. The contract allows lenders to decline to refinance if the interest rates increased more than 5 percent.
- Borrowers who are having difficulty with payments may find it hard to refinance the balloon. The contract allows for lenders to decline to refinance if the borrower missed just a single payment. No problem with the adjustable-rate mortgage.
- Borrowers incur refinancing cost with a 5 or 7 balloon loan. With an adjustable-rate mortgage, borrowers do not unless they refinance.
- Balloon mortgages are easier to understand.
- The interest rates on an adjustable-rate mortgage are higher than a balloon mortgage.
What are the Advantages and Disadvantages of a Balloon Mortgage?
The most desirable feature of the balloon mortgage is that it has the lowest interest rates compared to other mortgages on the market. You make small monthly payments and can qualify for a huge loan than a fixed or adjustable-rate mortgage. The rates can either be adjustable or fixed depending on the terms of the lender. The loan may also be adjusted in a way that allows the borrower to make low monthly payments and finally make a lump sum amount during maturity. The duration can range from 2-30 years and you can make an early repayment without being penalized. In case you’re expecting a financial downfall before the term of the loan expires, you can avoid this by selling your home before loan maturity.
You can Re-calculate Your Mortgage
As a borrower, balloon mortgages allow you to re-calculate your loan based on current interest rates then use the newly calculated payment terms to pay the remaining loan. However, for you to qualify for this, there are conditions that you should meet. The terms include:
- No delinquency in loan payment within the past one year.
- You should be living in the property and,
- There should be no liens on the property in question.
Ability to Refinance with Another Loan
When a balloon payment is due, there is an option that can enable you to pay off the amount which is—obtaining an additional loan or simply refinancing. The newly obtained loan helps to spread the loan’s repayment period. For instance, if it’s a 7-year loan, then you can add another 5 years. You can refinance a property loan into a 15 or 30-year loan. The challenge, however, is that you have to maintain good credit along with assets and income to be able to qualify for the new loan.
The Liability is Paid Off Quickly
The advantage of taking a balloon mortgage is that the loan that you owe is paid off quickly. In case you have cash, you can pay the loan off when it’s due. Other options can help you pay the loan like selling an asset especially the one you bought using the loan. One thing to note is that properties with this loan do sell quickly. If you have a good credit rating, you can receive an attractive interest rate on the property. This is what most people refer to as fast and bulk repayment. If you utilize the loan properly, you can get a small fortune for yourself from the loan.
Payment can be Made Any Date
There are no strict and stringent rules when it comes to paying off a balloon mortgage. You can make payments at any date and the rule applies to various mortgages that have the clause of a balloon mortgage in their agreement.
Resource – The Complete Dictionary of Mortgage & Lending Terms
Short repayment time is the most prominent drawback of a balloon mortgage. Although the payments are usually calculated on a 15-30-year amortization schedule, the loan’s maturity is 5- 7 years. It means you need to have the money handy to make the balloon payment once the date is due. This can be a big challenge in case you’re trying to cope up with financial windfalls. It may also force you to sell your property or find another refinancing option. The worst is that if the rates have changed or your credit rating has deteriorated, then your chances of getting an affordable mortgage will be minimal. Additionally, you may not be certain whether your property will sell for you to pay off the loan. The whole idea of having to lose your property to pay off the loan is a big drawback.
High Risk of Default and Bankruptcy
While default and running bankrupt may be the last thing to expect when borrowing a loan, it commonly happens. Remember that although you’re paying the interest in the monthly payments, you are not accumulating any equity.
The Reset Option May be Undesirable
Some of the loans come with a reset feature at the end of a specified term. In such a case, your interest rates are reset based on prevailing amortization schedule and rates. The adjustments are made to suit the loan term left but whether your loan comes with a reset option or not, you might be compelled to sell your property to finance the original loan before it matures.
Unpredictable Rates May Lead to Losses
If you the borrower decides to pay off the loan and the real estate rates have decreased, then you might suffer great losses or even be left with a worthless property. Alternatively, if you decide to convert it to a regular mortgage, then you might face even sheer rates.
It is Expensive in the Long Run
While you may view the small interest rate payments as low, the final figure that you pay is quite large compared to a traditional loan.
What are the advantages and disadvantages of a balloon mortgage? Depending on your situation, this loan can either be favorable or unfavorable. It is vital to understand how it works first before taking the loan. It can be a good option if you have a lump sum amount to pay in the end but if you are unsure of getting a balloon amount, then you may opt for another loan.
 Guttentag, J. (2010). The Mortgage Encyclopedia. New York, NY: McGraw Hill.