A balloon payment mortgage is a type of home loan where you make smaller regular payments for a period of time, but at the end of the mortgage term, there is a big one-time payment that you have to make. This final payment is usually much larger than the earlier payments and covers the remaining balance of the loan.
- What is a balloon mortgage?
- How does a balloon mortgage work?
- How does a balloon loan differ from other loans?
- Balloon mortgage pros and cons
- How to get rid of a balloon payment mortgage
- Should you take out a balloon mortgage?
- Balloon mortgage alternatives
What is a Balloon Payment Mortgage?
A balloon Payment mortgage starts with regular payments that remain the same for a set time, and then concludes with a large lump-sum payment. This final payment is known as a balloon payment because it is significantly larger than the initial payments. Typically, the balloon payment is at least twice the average monthly payment of the mortgage. In many instances, balloon payments amount to tens of thousands of dollars.
Balloon loans were more prevalent in mortgage lending before the Great Recession of the mid to late 2000s. These loans attracted homebuyers with their smaller initial payments, as they sought affordable mortgage options.
The common strategy for buyers was to refinance their loan before the balloon payment is require. However, when the housing market experienced a significant decline during the financial crisis, many homeowners found themselves unable to refinance their loans. As a result, those who couldn’t make the balloon payment faced difficulties and often went into mortgage default.
Fortunately, regulations implemented after the Great Recession have largely phased out balloon mortgages. However, there are still some lenders who provide mortgages with a balloon payment option. These types of loans, known as balloon notes, are more prevalent in portfolio lending, private lending, and construction financing. Tabitha Mazzara, the director of operations at the Mortgage Bank of California (Mbanc), explains this trend.
How Does a Balloon Mortgage Works?
The terms of a balloon mortgage can vary based on the lender and the specific loan agreement. Typically, a balloon note involves making fixed payments for a certain duration, followed by a large balloon payment at the end.
During the initial period of a balloon mortgage, the payments are usually lower because the loan is not fully amortized. Amortization refers to gradually repaying the loan through regular payments that reduce the outstanding balance over time. In some cases, the payments made during the fixed period may even cover only the interest portion of the loan.
Balloon Payment Example
To illustrate how a balloon mortgage is repaid over time, we will look at two balloon payment examples: one with interest-only payments and one with principal and interest payments.
Five-Year Balloon Mortgage With Interest-Only Payments
In this balloon payment exampled, the principal amount is $200,000, and the interest rate is 5%.
|Year||Monthly payment||Principal balance at year-end|
Since the payments made during the fixed period of a balloon mortgage are interest-only, the principal balance of the loan does not decrease over the course of, let’s say, a five-year term. Consequently, at the end of this term, a balloon payment of $200,000 would be due to settle the remaining principal balance of the loan.
10-Year Balloon Mortgage With Principal and Interest Payments
In this example, let’s consider a $200,000 principal amount with a 5% interest rate. The balloon payment scenario involves a 10-year term, but the monthly payments are calculate base on a 30-year amortization period. As a result, the monthly payments are much smaller compare to a fully amortized 10-year loan.
|Year||Monthly payment||Principal balance at year-end|
Due to the calculation of balloon loan payments using a 30-year amortization period, even though the loan term is only 10 years, the scheduled payments are not sufficient to fully repay the loan by the end of the term. While the loan balance gradually decreases over time as the payments cover both principal and interest, it does not decrease enough to completely pay off the loan by the specified due date. Consequently, a balloon payment of $162,683.08 would be required at the end of the loan term to settle the remaining balance.
When is the Balloon Payment Actually due?
The payment for a balloon mortgage loan is typically required on the loan maturity date, which is the date when the mortgage becomes due in full. For instance, in a five-year balloon mortgage, the balloon payment is due at the end of the five-year term and serves to pay off the remaining balance of the loan. The specific due date for the balloon payment is determined by the loan terms and is established at the start of the balloon mortgage.
How Does a Balloon Loan Differ From Other Loans?
In addition to having a lump-sum payment due at the end of the loan, balloon mortgages differ from other loan types in a few ways.
A notable distinction of balloon loans is the types of lenders that offer them. Balloon payments are among several features that is not permit in most qualify mortgages, which are loans that adhere to specific guidelines and are consider stable. Consequently, balloon payments are not allowed in many mortgage products and are usually offered by smaller or private lenders. They may also be available for certain types of lending, such as construction loans.
The eligibility criteria and underwriting process for balloon mortgages can vary from those of qualified mortgages. Since balloon notes do not fall under the category of qualified mortgages, lenders who offer them set their own requirements. Non-qualified mortgages, including balloon notes, generally have stricter borrower criteria, such as higher credit score requirements and larger down payment amounts. These additional requirements are put in place by lenders to mitigate the risk associated with balloon mortgages
Balloon mortgages also differ from other loans in terms of interest rates. Typically, balloon mortgage rates are higher compared to other loan types. This is due to the increased risk that lenders assume when offering balloon mortgages, as mentioned by Mazzara. The higher interest rates help compensate lenders for the added risk involved in these types of loans.
Balloon Mortgage Pros and Cons
According to Mazzara, balloon loans are not recommends for the average consumer. They are better suite for experience investors. However, even in the case of experienced investors, caution should be exercised. Let’s explore the advantages and disadvantages of balloon mortgages.
You will have low initial payments: The monthly payments during the fixed period are usually smaller than a fully amortized loan, especially if the balloon mortgage is interest-only.
A Home can be Bought Soon: Buyers expecting a significant income increase or lump-sum payment down the road can leverage a balloon mortgage to purchase a home sooner without waiting for the funds.
You may have a faster processing time: Many lenders that issue balloon notes offer a much shorter underwriting process than other loan types.
You can finance investment rehabs: Fix-and-flip loans (which have balloon payment features) will allow buyers to complete the construction project while making low monthly payments. However, as a borrower, you need to be careful with these loans. They often come with high interest rates and fees.
You will have fewer documentation requirements: Depending on the loan terms and the lender, a balloon mortgage may not require a home appraisal or other documentation typical of traditional financing.
You could lose your home: Unless you are sure you’ll have the money to pay off the loan, a balloon mortgage is quite risky. If you can’t make the balloon payment, your lender can foreclose on your home.
You may have to borrow more money: If you are unable to make the balloon payment when it becomes due, you may resort to taking out another loan to cover it.
You will build equity slower: With balloon payment amortization, the monthly mortgage payments preceding the final balloon payment don’t pay off a lot of principal — in the case of interest-only loans, none at all. As a result, balloon payment loans build little-to-no home equity and may be hard to refinance.
You may have a harder time qualifying: Lenders offering balloon mortgages may require a high credit score or down payment.
You will have higher interest rates: Balloon mortgage rates are often higher than interest rates on qualified mortgages because of the risk involved. Consumers can typically get better rates with standard loan options, such as traditional conventional mortgages, FHA, VA and USDA loans.
How to get rid of a Balloon Payment Mortgage
Mazzara, who has assisted borrowers in transitioning from balloon mortgages to more stable loan options, emphasizes that escaping a balloon mortgage can be difficult. However, there are a few potential ways to address this situation. Here are some options to consider for resolving a balloon payment mortgage.
Refinance the Balloon Mortgage
Refinancing the loan to another mortgage before the balloon payment becomes due is one possible solution to address a balloon payment. Mazzara highlights that many borrowers are assist in transitioning out of these types of loans through refinancing. Refinancing can provide a way to navigate through the balloon payment and secure a more favorable mortgage arrangement..
Pay off the Balloon Payment
Naturally, the balloon payment can be eliminate by actually making the payment as require by the balloon note. There are several options to consider when making the balloon payment. These include saving up the lump sum over the fixed payment period, utilizing expected funds or savings, or potentially borrowing the necessary amount to fulfill the balloon payment obligation.
Sell the Home
Borrowers unable to make the balloon payment by the due date can sell the property to avoid defaulting on the loan.
Pay More During the Initial Period
Assuming the loan doesn’t have a prepayment penalty, paying more during the initial period will reduce the principal due at the end of the loan term.
Negotiate an Extension
Homeowners who are unable to make the balloon payment on time may have the possibility of negotiating an extension with the lender. However, it is important to note that this option often involves substantial fees and may only grant a short-term extension.
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Should you Take out a Balloon Mortgage?
According to Mazzara, for most consumers, the risks associated with balloon mortgages outweigh the potential benefits. She suggests that balloon notes should not be offered for owner-occupied residences. Instead, she believes they are more suitable for experienced real estate investors who have a strong understanding of market dynamics and are comfortable with the terms and risks involved in a balloon note. she says.
Here are some scenarios where a mortgage with a balloon payment could provide advantages.
You can Already Afford the Balloon Payment
In certain situations, borrowers who have the necessary funds for the balloon payment may choose to invest the money or utilize it for other purposes until the payment is due. In such cases, opting for a balloon mortgage carries less risk because you already possess the funds required for the lump-sum payment.
You are Expecting a Lump sum Before the Balloon Payment is due
A balloon mortgage can be a suitable option if you anticipate receiving a significant inheritance, bonus, or lump sum payment in the future.
You are Expecting an Income Increase
Borrowers who anticipate a substantial income increase in the near future can utilize a balloon loan to buy a home even when their current income is relatively low. This can be beneficial for individuals in professions where income is initially lower but is expect to rise significantly over time. By opting for a balloon mortgage, they can secure a home without having to wait for their income to increase.
You are Only Looking for Short-Term Financing
Investors looking to flip a house often leverage balloon mortgages to buy and rehab a home and sell it within a short time.
You Plan to Live in the Home for a Short Amount of Time
A balloon payment may be a viable option for homeowners who intend to own the property for a relatively short period and sell it before the balloon payment becomes due. However, it’s important to consider the potential risk involved. If the value of the home decreases during this time, there is a possibility that you may need to cover the shortfall between the sale price of the property and the remaining loan balance.
Balloon Mortgage Alternatives
If a balloon mortgage isn’t the best fit for you, here are some alternatives to consider.
In the past, individuals looking to finance the construction of a new home had to obtain interim construction financing from a bank. However, lenders now have the capability to offer one-time construction loans.
These loans typically start as interest-only loans during the construction phase and then convert into mortgages with principal and interest payments once the construction is complete. This option can be consider a safer alternative to loans with balloon payments, providing borrowers with more stability and eliminating the need for a large lump-sum payment at the end of the loan term.
An adjustable-rate mortgage (ARM) offers similar advantages to a balloon loan, although it comes with different risks. Initially, ARMs typically have lower interest rates and monthly payments, allowing homebuyers to potentially qualify for larger mortgages when purchasing a home.
Unlike balloon loans, an ARM does not require the entire balance to be repaid at once. Instead, the interest rate and payments adjust periodically throughout the loan term after an initial fixed period.
To assess whether the initial savings are worthwhile, borrowers can request their lender to provide an estimate of the highest payment they might encounter under the ARM. This allows borrowers to evaluate whether the potential benefits outweigh the associated risks.
Federal Housing Administration (FHA) Graduated Payment Mortgages
A graduated payment mortgage supported by the Federal Housing Administration (FHA) is a type of loan where the payments gradually increase over a span of several years. These loans are design for individuals who wish to purchase a home but may not currently have the financial means to afford the full payments upfront. The loan program is consider a secure alternative to balloon mortgages due to its inherent features that help ensure borrowers can manage the increasing payments as they gradually rise over time.
A mortgage with an extended term, such as 40 years, will result in lower monthly payments in comparison to a loan with a shorter amortization period. This can provide a more stable alternative to a balloon loan.
However, it is important to note that over the course of the loan’s lifetime, you may end up paying more in interest due to the longer repayment period. Furthermore, mortgages with longer terms often come with higher interest rates compared to loans with shorter terms.
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