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How Does A Balloon Mortgage Work?

7-minute readSeptember 21, 2020

A balloon mortgage requires a lump-sum payment at the end of the term. They give you access to lower interest rates but require you to pay a large sum of money when the loan matures. Though balloon mortgages are rare, you may be able to use one to save money. 

We’ll introduce you to the concept of a balloon mortgage and show you how these loans work. We’ll also introduce you to a few alternative types of mortgages you can use to buy the home of your dreams.

What Is A Balloon Mortgage?

A balloon mortgage begins with the same structure as most mortgages. You agree to a loan principal with your lender and agree to make fixed-rate monthly payments after closing. Monthly payments on a balloon mortgage are usually very low. In some cases, you may only have to pay accumulated interest each month. Balloon mortgages have much lower interest rates compared to other types of mortgages.

Balloon mortgages have shorter terms than other types of mortgages as well. The average one has a term of 5 – 10 years. When you reach the end of your term, you must pay the remaining balance. If you cannot make the lump-sum payment, you may have the option to refinance.

A balloon mortgage can be a good idea if either of the following scenarios apply to you:

  • You don’t have enough money to make a lump-sum payment now, but you know that you’ll receive a large windfall of cash in a few years.
  • You know that your income will increase within the next 5 years.

You gain access to lower interest rates and you pay less in interest over time when you take on a balloon mortgage. However, these mortgages are very risky for lenders. Most people don't have hundreds of thousands of dollars to pay off their mortgage in a lump sum. Your lender may offer you a different type of loan if they don’t think you’ll be able to make your large final payment. You might have a hard time finding a lender willing to give you a balloon mortgage unless you have very convincing proof that you’ll be able to pay it off.

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What Happens When A Balloon Mortgage Is Due?

At the end of your mortgage term, you have two options: pay off the remaining balance of your loan or request a refinance.

Let’s say you choose the first option. You’ll need to pay off the entirety of your loan minus what you’ve already paid in principal. This can add up to a major sum of cash. Let’s take a look at an example.

Let’s say you buy a home with a $150,000 loan and you take a balloon mortgage with a 7-year term and a 3% APR. Each month, you’ll pay about $632 to your mortgage company. You’ll make this fixed payment every month for 7 years. After your loan expires, you’ll need to pay off the remaining $126,605 on your loan in a single lump sum. Once you make your payment, you own your home.

The total amount of interest you paid in this example is about $29,000. If you took the same loan with a 30-year term, you’d pay almost $78,000 in interest by the time you make your final payment. A balloon mortgage can save you thousands of dollars – but only if you can make your final payment.

If you cannot make your lump-sum payment, you may be able to refinance your loan. When you refinance, you take on a new loan for your remaining balance and pay it off in monthly installments. Your lender isn’t obligated to refinance your remaining balance at the end of your mortgage term. You may be at risk of losing your home if you can’t make your balloon payment and your lender won’t accept a refinance.

Why Would Someone Get A Balloon Mortgage?

Think you might want a balloon mortgage? There are a few good reasons to get one:

  • A balloon mortgage gives you access to lower interest rates than other types of loans.
  • They cost less because they have lower interest rates and you make fewer payments.
  • Balloon mortgages also allow you to move into your home sooner and help you avoid large monthly payments.

Balloon mortgages are very risky for lenders, so they’ve become a rare product. You might have a hard time finding a lender willing to give you this type of loan, especially if you can’t prove that you’ll be able to make your lump-sum payment. You might want to consider a few other mortgage loan types to buy a home.

Balloon Mortgage Alternatives

If you’re having a hard time finding a balloon mortgage, consider one of these loan alternatives. 

Adjustable Rate Mortgage (ARM)

An ARM loan has an interest rate that changes along with market rates. When you sign onto an ARM, you begin with an initial fixed-rate period. This initial repayment period usually lasts 5 – 10 years. The introductory interest rate you receive will be lower than current market rates and lower than what you could get with a fixed-rate loan. At the end of your fixed-rate period, your interest rate may increase or decrease, depending on how market rates move. ARMs have caps in place that limit how high your interest rate can rise. This means that you won’t have to worry about getting stuck with a loan that has an interest rate that’s 10 times higher than what you signed up for. 

ARMs offer a great alternative to balloon mortgages because they give you access to a lower initial interest rate for at least a few years. During your initial repayment period, you pay less in monthly payments than you would with a fixed-rate loan. You can usually make a lump-sum payment toward your loan balance like you would with a balloon mortgage at any time. Make sure that your ARM loan terms don’t include a prepayment penalty if this is your plan.

If your plan falls through and you don’t receive the windfall of cash you were expecting, there’s no penalty. You can continue to make your payments on your ARM’s schedule until you own your home. You can also refinance your loan to a fixed-rate or longer term if you have trouble keeping up with your payments.

Fixed-Rate Mortgage

A fixed-rate loan is a type of home loan that holds a steady interest rate throughout its term. Your lender guarantees that your interest rate will stay the same when you sign onto a fixed-rate loan. This is true regardless of whether market rates go up or down. With a fixed-rate loan, you’ll pay the exact same amount every month unless you fall behind on your loan or you make an extra payment. A fixed-rate loan can be a great choice if you need a predictable monthly payment.

Like an ARM, you can usually make additional payments on a fixed-rate loan without issue if your loan terms don’t include a prepayment penalty. If you do decide to pay down your loan early, make sure you tell your lender that you want your extra payments to go toward your loan principal. Some lenders automatically apply any extra money you put down toward your next month’s payments. Also, like an ARM, there is no looming lump-sum payment you must make to stay in your home. You’re free to continue making your monthly payments or refinance if you don’t receive the money you were expecting.

Interest-Only Mortgage

An interest-only mortgage can allow you to move into your new home without a high monthly payment. Interest-only mortgages begin with a set introductory period. During this time, you’ll only need to pay monthly interest that accrues on your loan. When your introductory period ends, your mortgage company recalculates and restructures your loan and you switch to a standard monthly payment structure.

Interest-only loans can be a good alternative to balloon mortgages. Let’s say you have a low income now but believe that your income will significantly increase in a few years. An interest-only mortgage can allow you to move in without a waiting period. However, interest-only mortgages will cost more over time than ARM or fixed-rate loans. Interest-only loans are also less common than fixed-rate and ARM loans, so you may need to contact a few lenders before you find one.

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Summary

A balloon mortgage is a type of mortgage that begins with low monthly payments and ends with a single large balloon payment. Most balloon mortgages have very short terms, usually 5 – 10 years. During your loan term, you make standard monthly payments that include principal and interest. Some balloon mortgage lenders may allow you to only pay off accrued interest during your term. When your term ends, you must pay off the remainder of your principal balance. In some cases, you may be able to refinance your remaining balance, but this isn’t guaranteed.

Balloon mortgages require a large lump-sum payment. You’ll have a hard time getting a balloon mortgage if you don’t have solid proof that you’ll be able to make your payment when your loan matures.

An ARM loan can be a great alternative to a balloon mortgage because you’ll get an introductory period with a low fixed interest rate. Even better, you won’t lose your home if you cannot make a massive lump-sum payment when you have an ARM. Fixed-rate loans and interest-only mortgages are also more common than balloon mortgages but will cost you more over time. For other articles on mortgages, visit our personal finance and home buying learning centers.

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