A balloon mortgage is usually a short-term fixed-rate loan which involves small payments for a certain period of time and one large payment for the remaining amount of the principal at a specific time.
A balloon mortgage is a mortgage that does not fully amortize over the term of the loan, and therefore, a large portion of the principal balance is repaid with a single payment at the end of its term (hence the term, balloon payment)). Typical terms are five or seven years.
A balloon mortgage is not fully amortized. With a fully amortized loan, the final payment is meant to pay off the principle of the loan. However, with partial amortization, there is a large portion of the loan still unpaid. This results in the need for a balloon payment at the end of the term.
The borrower’s monthly payment is calculated using a longer term, usually 30 years, to keep the monthly payment affordable. However, this lower payment means that at the end of the mortgage term, a very large balance remains. It can be zeroed out with a single payment, or the borrower may be able to refinance it.
The advantage of this loan is a lower mortgage rate and payment. If, for example, 30-year fixed rates are 4.00 percent, a five year balloon mortgage might have an interest rate of 2.5 percent. For a $200,000 home loan, the 30-year loan payment would be $955, while the balloon mortgage payment would be $790. However, after five years, the remaining $176,151 balance would have to be repaid or refinanced.
The risk is that there is no guarantee of being approved for a new loan, nor any way of knowing what interest rates might be at that time.
Borrowers interested in a balloon mortgage should also compare it to adjustable rate mortgages (ARMs). The 5/1 ARM, for example, may be available at a similar interest rate, but offers a little more protection because rate increases in years six through 30 are capped.