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Balloon mortgages are loans that are not fully paid off at the end of the loan. Instead, with a balloon mortgage, a significant part of the loan amount is due as a one-off payment at the end of the loan term. These loans are not often used for consumer finance. But while they are often not ideal, they are sometimes the best option when long-term funding is not an option.
What is a balloon mortgage?
A balloon mortgage is a type of loan that is not structured to be paid off through normal monthly payments alone. Instead, balloon mortgages are issued for set periods of time with low monthly payments that may only cover accrued interest. At the end of the term, there is then a credit balance that the borrower must either pay off or refinance.
This is how a balloon mortgage works
In terms of finance, balloon mortgages are not “fully amortized”. In other words, these loans are structured with monthly installments that they would pay off over a period of time that is longer than the actual term of the loan. This leaves a residual amount at the end of the loan term that the borrower has to pay.
Like any other loan, all balloon mortgages share certain common features, including:
These characteristics are used by the lender to calculate the monthly (or quarterly) payments to be made regularly by the borrower, as well as the balance owed at the end of the mortgage.
In practice, most balloon payments are made with the proceeds of a new loan rather than cash. The borrower simply refinances the loan – sometimes through the same lender.
In some cases, balloon mortgages can provide borrowers with access to lower interest payments or rates than they would otherwise get with a long-term loan because short-term balloon loans are less risky for lenders. Payments can even only bear interest.
In other cases, lenders simply do not want to provide long-dated loans, sometimes due to the risk of the loan, the creditworthiness of the borrower, or the dollar value of the asset being funded.
When a lender issues a balloon loan, the loan includes monthly payments that are based on an underlying schedule. Usually these payments are structured according to a normal amortization schedule, just like a conventional credit, but the repayment schedule is longer than the repayment term.
For example, a borrower can get a five-year loan with a 25-year repayment. In this scenario, the loan will only last five years, but the amortization schedule calls for payments of 25 years. At the end of the loan term, there is a residual amount that the borrower has to repay in one sum.
Lump sum payment
In the example above, at the end of the five-year loan period there would still be a residual amount of the loan that the borrower would have to repay either in cash or with the proceeds of a new loan Refinancing the loan.
Of course, all of this assumes that the borrower does not make so many additional payments that he pays off the entire balloon ahead of time. However, this is certainly an option. Many homeowners who purchase property with balloon mortgages make additional payments over the life of their loan to minimize or eliminate their balloon payment.
More often, however, balloon payments are refinanced. However, it is important to note that this is a new loan, not an extension. Borrowers will have to go through a whole new underwriting process, pay fees and possibly get new ones Assessment or inspections.
Example of a balloon mortgage payment plan
Consider the following example based on a $ 200,000 balloon mortgage provided at 5% with a five-year term and a 25-year payback:
Under the above schedule, the borrower would make regular monthly payments of $ 1,169.18. If the borrower made these payments for 25 years, the loan would be repaid in full. However, this loan expires after five years. At the end of the five-year loan period, the borrower has a remaining balance of USD 177,160.38 that he has to pay in one lump sum.
Who Should Get a Balloon Mortgage?
Balloon mortgages are not correct in all cases. They are considered much riskier mortgage products for borrowers – and many lenders don’t even offer them because they owe large lump sums to borrowers that they may not be able to afford without taking out a new loan. However, in some cases, a balloon mortgage is the best option.
Two main cases in which balloon mortgages make sense are:
- A borrower may not qualify for a long term fixed rate loan because their income will fluctuate
- A purchase is structured with seller funding (the buyer pays a down payment and then makes regular payments to the seller, just like a bank loan), but the seller doesn’t want to hold a promissory note for more than five or 10 years
In other cases, a balloon mortgage may be the only option available. This includes purchases of large assets such as business equipment, boats, or planes. In these situations, many lenders offer five or ten year loans with a repayment of 15 to 25 years. In all of these cases, borrowers would be due balloon payments at the end of their loan life, with payments often exceeding 60 to 70% of the original loan amount.
When should a balloon mortgage be refinanced?
There are several schools of thought when it comes to balloon mortgage refinancing. Some borrowers are willing to withhold the refinance until near the end of their repayment term when their balloon payment comes due. This allows them to wait until their loan balance is at its lowest and may also secure a lower interest rate for themselves if interest rates go down.
However, borrowers may be better off refinancing their balloon payments once they qualify for a long-term loan. Or, if they are unable to complete a long loan term, borrowers should still begin refinancing 12 to 24 months before the balloon payment is due. This gives them plenty of time to correct any credit issues, arrange for estimates or inspections, and work through their lender’s underwriting process.
If a borrower fails to refinance and repay their balloon mortgage, they are technically in default and could lose their property even after making all of the monthly payments. This is why it is important to refinance a balloon mortgage sooner rather than later.
Alternatives to balloon mortgages
Balloon mortgages are typical of some commercial credit situations, but are not often used for consumer credit such as mortgages. When it comes to home loans, there are several alternatives, including:
There are also often alternatives to balloon loans for business loans, which can offer significantly lower-risk financing. These can be loans from the US Small Business Administration (SBA) or, in the case of equipment purchases, in-house financing solutions from dealers or suppliers.
Advantages of the balloon mortgage
- Interest rates can be lower than long-term loans (0.5% to 2.0% depending on creditworthiness)
- Lower eligibility requirements as lenders are less concerned about long-term credit risk
- May be an option when conventional funding is not available
- Payments can only consist of interest
Disadvantages of balloon mortgages
- Borrowers must be able to repay or refinance the balloon payment
- The interest rate can go up when refinancing the balloon
- Refinancing may incur new loan fees