The joys of owning a home are doubled when your monthly mortgage payments are affordable, and you still have money in the bank to spend guilt-free or park into a savings or retirement account. #FiscalResponsibility
Figuring out how to live your best life while comfortably making your mortgage payments every month should incentivize you to get familiar with different mortgage financing options.
One of those financing options is the balloon mortgage.
Balloon mortgages can require small monthly payments. At the end of the loan, you make one large balloon payment to pay off the remaining balance.
Thanks to their low initial cost, balloon mortgages are pretty popular with property developers and house flippers. But, for the average homeowner, it can be a risky option. Making one larger-than-average payment after making smaller payments for months can be financially difficult to manage.
Like balloons, these mortgages may sound fun, but there’s always a chance that they could burst! Let’s explore whether balloon mortgages are full of hot air or just the option you’ll need to sail toward your best financial life.
What Is a Balloon Mortgage?
Balloon mortgages – which are usually offered for short terms, typically between 5 – 7 years or even 2 years – usually require low payments over the loan’s term. At the end of the loan, the homeowner pays back the loan’s remaining balance.
Additionally, balloon mortgage interest rates are often relatively low compared to other mortgages, such as conventional mortgages.
If your balloon mortgage requires payments, you’re typically paying the interest that accrued over the month. (But some balloon mortgages don’t require monthly payments.)
Whether the homeowner is making monthly payments or not, at the end of the loan, the borrower must make one, large lump-sum payment for the entire balance, including any outstanding interest. That means that you’ll need a lot of cash on hand to pay off the remaining balance.
How a Balloon Loan Differs From Conventional Loans
With a conventional mortgage, the loan term is the same length as the amortization schedule. Because of this, the entire mortgage gets paid off by the end of the loan.
Let’s say you’re making monthly payments of $1,300 for 30 years with a conventional mortgage. In the beginning, the majority of your payment will go toward interest, with the rest going toward your principal balance. Over time, as you pay down your loan balance, less of your payment will be applied to interest. Eventually, the majority of your payment will go toward principal. This is how you steadily pay down your mortgage over your loan term.
With a balloon mortgage, the loan term is shorter than the amortization schedule. A balloon mortgage offers the flexibility of low or no payments every month, but at the end of the term, the borrower has to pay the remaining loan balance in one large lump sum. So, instead of gradually paying off the loan over 15 or 30 years, you settle your balance all at once after a period of low or no payments.
How Does a Balloon Mortgage Work?
There are different balloon mortgage types and structures, but they all feature a lump-sum payment in the end.
There are three common types of payment structures:
Balloon payment mortgage
The balloon payment mortgage is the most common type of balloon mortgage. Your loan structure might look something like this:
- The mortgage amortization will be based on a standard term of 15 or 30 years. Because the balloon mortgage’s term will be shorter than the loan’s amortization period, you’ll have to pay off the remaining loan balance at the end of the loan’s term.
- Payments (which are made up of interest and principal) are made according to your amortization schedule. Like other fixed-rate mortgages, during the first few years of the loan, a larger chunk of your payment will go to interest than the loan or principal balance.
- Depending on the mortgage’s structure, payments usually only cover the interest portion of the loan with a small percentage going toward principal, leaving most of the principal (aka the original amount of the loan) due at the end of the loan.
With the interest-only option, you pay the interest that accrues every month, and at the end of the loan’s term, you pay the outstanding mortgage principal.
For example, if you took out a $300,000 mortgage with a 5-year term, you’d owe $300,000 at the end of the 5 years.
No monthly payments
The last option is to make no monthly payments. Everything – the interest, fees and mortgage principal – is due at the end of the loan.
This payment structure is usually only offered as a very short-term loan, like 1 year.
So, how much would you owe if you took out a $300,000 mortgage with a 1-year, no-payment loan? At the end of the year’s term, you’d owe the entire $300,000 plus all the fees and interest.
The no-monthly-payments balloon mortgage is pretty common with fix-and-flip projects. Your risk tolerance needs to be pretty high for this type of loan. Unless you can flip a home during that year, you might get stuck with a hefty bill.
What a Balloon Mortgage Payment Schedule Can Look Like
The payment schedule for a balloon mortgage is based on the type of balloon mortgage you get (interest only, balloon payment mortgage or no payment).
The balloon payment mortgage is the most popular option because it allows you to reduce the loan’s principal, which helps reduce the size of the final lump-sum payment. Remember, this type of payment structure is based on the amortization schedule of a 15- or 30-year loan.
Let’s say you have a $300,000 mortgage with a 5-year loan term and an interest rate of 3.66% on a 30-year amortization (aka payoff) schedule.
Your monthly mortgage payment would be $1,374.07 (not including any additional costs like private mortgage insurance (PMI), property tax, home insurance, etc.).
At the end of 5 years, your final or balloon payment would be $269,824.76.
When Is a Balloon Mortgage a Good Idea?
A balloon mortgage can be a desirable option for a buyer who doesn’t plan on staying in a home for long. The borrower can take advantage of low monthly payments and can sidestep the lump-sum payment entirely by selling the home before their loan term ends.
Ideally, this loan can keep your cost of living lower and more affordable. And you get the added bonus of possibly walking away with a healthy profit after selling the property.
You can also dodge the lump-sum payment by refinancing your loan right before payment’s due. Borrowers might choose to refinance if they think they’ll be in a better financial situation when they refinance, getting an interest rate reduction.
The Risks of a Balloon Mortgage
There are serious risks to consider with balloon mortgages.
If you’re planning on selling the home to cover the balloon payment, you’re essentially betting on selling your home for exactly what you bought it for or – if the market has gone up – selling it for more by the time your balloon payment is due.
No one can predict the housing market. If the market is in a slump when you’re ready to sell, you might not make enough to cover the lump sum. You might walk away from the sale without a significant profit or – worst case scenario – you might not be able to sell the home.
Homeowners who plan on refinancing before they have to make the final payment will have to rely heavily on two things: improved personal credit and lower interest rates.
If you experienced unexpected financial hardships (like a job loss or surprise medical bills), refinancing with good terms might be challenging. You also have to consider the current state of interest rates. The risk is that interest rates could be significantly higher by the time you refinance. An increase of even half a percentage point could add thousands to your mortgage loan.
Lastly, balloon mortgages tend to carry a higher risk of foreclosure. When you take out any mortgage, your property acts as the collateral on the loan. If you can’t sell the home, refinance or pay off the lump-sum payment when it’s due, the property can be foreclosed on.
How Can I Pay Off a Balloon Mortgage?
There are several ways to pay off a balloon mortgage:
- Refinance the mortgage: You can refinance your mortgage for the remaining balance before the lump sum is due. To qualify for a refi, you’ll need good credit, a steady income and a qualifying debt-to-income (DTI) ratio.
- Sell the home: You can choose to sell the home to pay off the outstanding loan balance. Ideally, you’ll be able to sell the home, walk away with everything paid off and pocket a decent profit. But if the market is in decline, you might not sell at all, or you might sell at a loss, leaving you to figure out how to cover the remaining balance of the lump-sum payment.
- Save before buying a balloon mortgage: You can opt to save a lot of money before you apply for a balloon mortgage. With a cash reserve, you’ll know that you have the money to pay off the lump sum when it’s due. If this option is available to you, you’ll own a property and be mortgage-free in 3 – 5 years!
- Put money aside while waiting for your balloon mortgage deadline: You can set aside cash during the balloon mortgage loan (almost as if you were paying off a conventional mortgage) so you can afford the lump-sum payment at the end of the term. To figure out how much you have to set aside to cover your loan, divide your loan balance by the number of months you have left until the balloon payment is due.
What Are Some Alternatives to Balloon Mortgages?
Don’t know if a balloon mortgage is right for you? You may want to consider a few other options before you make a final decision.
Some alternative mortgage options that can come with lower monthly payments include:
Adjustable-rate mortgages (ARMs) typically have 30-year terms. At the beginning of the loan, there’s a “teaser period.” This period usually lasts between 5 – 10 years and offers a lower interest rate than you would get with a conventional fixed-rate mortgage.
After the teaser period is over, you can either refinance to a fixed-rate mortgage or you can continue with the adjustable-rate mortgage, which adjusts regularly to meet market interest rates. The adjustments continue approximately once or twice a year until the end of the loan.
The upside of an ARM is clear. You get to take advantage of a lower interest rate (and, therefore, lower payments) during the introductory period of the loan – and there’s no lump sum payment to deal with after the intro period.
A fixed-rate mortgage usually comes with a slightly higher interest rate than its alternatives, like the balloon mortgage or the adjustable-rate mortgage.
You can get a fixed-rate mortgage for a longer term, like 30 years, to get the lowest possible monthly payment. The advantage of the fixed-rate mortgage is stability. You know how much you owe every month; you know when it’s due, and you’ll know it’s completely paid off at the end of the loan.
Before deciding on the type of mortgage you want, think about how much house you can afford. A mortgage calculator is a great resource. It can give you some insight into your flexibility before moving on to the next steps of your home buying journey.
Get the Financing You Want: Know Before You Go
A balloon mortgage comes with many risks, but it might be a savvy financial move for someone who understands the process and is – or can be – prepared for any outcome.