What Is a Balloon Mortgage?
A balloon mortgage is a loan that has an initial period of low or no monthly payments, at the end of which the borrower is required to pay off the full balance in a lump sum. The monthly payments, if any, may be interest-only and the interest rate offered is relatively low.
These are, however, risky mortgages for homeowners and lenders.
Understanding the Balloon Mortgage
Balloon mortgages for homebuyers can be structured with varying terms and maturities and may have fixed or variable interest rates. Some short-term loans may require the borrower to make the principal and interest repayments at the maturity of the loan with no amortization over the life of the loan.
- A balloon mortgage is usually short term, usually 5 to 7 years.
- The monthly payments, if any, are low and could be interest-only.
- The entire balance of the mortgage is due at the end of the term.
Balloon mortgages can also charge interest-only payments which allow the borrowers to make low monthly payments before repaying the lump sum when it is due. Balloon mortgages may be issued for a term as short as two years, although terms of five to seven years are more usual.
Why Get a Balloon Mortgage
People who expect to stay in their home for only a short period of time may opt for a balloon mortgage. It comes with low monthly payments and a much lower overall cost since it is paid off in a few years rather than in 20 or 30 years like a conventional mortgage.
Others may intend to stay in their homes and refinance before the balloon payment is due. They may be counting on a higher income by then, and are sure they will be able to handle a larger monthly payment.
The balloon mortgage is risky. If the real estate market goes sour, the borrower could be in trouble.
The risks are obvious, however. The homeowner has little or no equity in the house and is counting on selling it or refinancing it for at least the amount of the balloon payment. In a slow or declining market, that might not be possible. Even if it is, that's not a great alternative for the buyer who had intended to sell the house and move on.
In a worst-case scenario, the lender may or may not agree to extend the deadline on the balloon payment or otherwise change the terms of the loan.
Another type of homebuyer who might find the balloon mortgage appealing is the professional whose main income comes as a year-end bonus. If that bonus is a certainty, it allows the buyer to get into the home earlier.
Balloon Loans for Business
The balloon mortgage is used often by businesses in the construction industry as a way to obtain short-term financing for construction projects without offering collateral. In this case, they are generally short-term loans that have higher interest rates than conventional collateralized business loans.
The construction company might take out a loan for a year or 18 months and then refinance with a lower-rate mortgage, using the newly-built structure as collateral.