Balloon Mortgage: What It Is and How It Works
Balloon mortgages are home loans with a large, one-time payment due at the end of the mortgage term. The final payment repays the loan in full and is often significantly larger than the initial payments.
What is a balloon mortgage?
A balloon mortgage begins with fixed payments for a specific period and ends with a final lump-sum payment. The one-time payment is called a balloon payment because it’s much larger than the beginning payments. The final payment is at least two times the mortgage’s average monthly payment, according to the balloon loan definition. In most cases, balloon payments are tens of thousands of dollars.
Balloon loans used to be more common in mortgage lending before the Great Recession of the mid to late 2000s. The small initial payments were appealing to homebuyers looking for affordable mortgages. Typically, buyers planned to refinance to a new mortgage before the balloon payment became due. Unfortunately, when home values plummeted during the financial crisis, many homeowners couldn’t refinance. And those unable to make their balloon payment went into mortgage default.
Fortunately, laws passed after the Great Recession have made balloon mortgages a thing of the past — almost. Some lenders continue to offer mortgages with a balloon payment. “Balloon notes are more common today in portfolio lending, private lending and construction [lending],” explains Tabitha Mazzara, director of operations at the Mortgage Bank of California (Mbanc).
How does a balloon mortgage work?
The specific terms of a balloon mortgage depend on the lender and the loan. Generally, a balloon note will have fixed payments for a particular period, followed by a balloon payment.
Balloon mortgage payments during the initial period are usually small because they aren’t fully amortized. Amortization refers to repaying a loan with payments that decrease the balance and pay off the loan over time. In some cases, the payments during the fixed period may even be interest-only.
Things You Should Know
A fully amortized mortgage has payments that lower both the loan’s principal and interest and will pay off the loan in full by the end of the repayment term. However, with balloon payment amortization, the initial payments don’t cover the total amount of principal and interest necessary to pay off the loan by the due date. That’s why there’s a balloon payment. The balloon payment at the end of the mortgage fully pays off the loan.
While balloon loan term lengths can vary, Mazzara says five-year balloon mortgages and 10-year balloon mortgages are standard.
Balloon payment example
To illustrate how a balloon mortgage is repaid over time, we’ll 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 example, the principal amount is $200,000, and the interest rate is 5%.
|Year||Monthly payment||Principal balance at year-end|
Because the payments are interest-only, the principal balance doesn’t decrease during the five-year term. In this case, a $200,000 balloon payment is due at the end of the loan term.
10-year balloon mortgage with principal and interest payments
Using the same $200,000 principal amount and a 5% interest rate, this balloon payment example has a 10-year term, but the monthly payments are based on a 30-year amortization, which makes them much smaller than a fully amortized 10-year loan.
|Year||Monthly payment||Principal balance at year-end|
Because the balloon loan payments are calculated based on a 30-year amortization but the loan term is only 10 years, the scheduled payments won’t pay off the loan by the end of the term. The loan balance decreases since the loan payments include principal and interest — but not enough to pay the loan off by the due date. So a $162,683.08 balloon payment is due at the loan’s end.
When is the balloon payment actually due?
The payment on a balloon mortgage loan is typically due on the loan maturity date — in other words, the date the mortgage becomes due in full. So, in the case of a five-year balloon mortgage, a balloon payment is due at the end of the five-year term and pays off the remaining loan balance. The exact due date of a balloon payment depends on the loan terms and is established at the beginning 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.
→ Lenders. One significant difference is the type of lenders that offer balloon loans. A balloon payment is one of several features not allowed in most qualified mortgages, loans that meet established guidelines and are considered stable. As a result, balloon payments aren’t permitted in many mortgage products and are typically offered by small or private lenders, or for certain types of lending, like construction.
→ Qualification criteria. Eligibility requirements and the underwriting process can also differ for balloon mortgages. Because balloon notes don’t fall into the category of qualified mortgages, lenders that offer them establish their own requirements. Non-qualified mortgages, including balloon notes, tend to have stricter borrower requirements, such as higher required credit scores and down payment amounts.
→ Interest rates. Another way balloon mortgages differ from other loans is in the interest rates. Balloon mortgage rates are typically higher because lenders are taking on a great deal of risk, Mazzara says.
Balloon mortgage pros and cons
Mazzara advises against balloon loans for the average consumer. Balloon mortgages are best suited for investors with extensive experience, she says. But even in that case, they should proceed with caution. Here’s a look at balloon mortgage pros and cons.
You’ll 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.
You can buy a home sooner. 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’ll 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’re 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’re unable to make the balloon payment when it becomes due, you may resort to taking out another loan to cover it.
You’ll 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’ll 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 helped borrowers move from balloon notes to more stable loans, says getting out of a balloon mortgage can be challenging. But there are a few avenues out. Here are some options for getting out of a balloon payment mortgage.
→ Refinance the balloon mortgage. One way out of a balloon payment is to refinance the loan to another mortgage before the balloon payment is due. “We take a lot of people out of those types of loans, and we help them navigate through it through refinance,” Mazzara tells LendingTree.
→ Pay off the balloon payment. Naturally, making the balloon payment will get rid of the balloon note. Options to make the balloon payment include saving up the lump sum during the fixed payment period, using expected funds or borrowing the money to make the balloon payment.
→ 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 unable to make the balloon payment on time may be able to negotiate an extension. However, this option is likely to come with significant fees and may result in only a short-term extension.
Should you take out a balloon mortgage?
For most consumers, the risks of balloon mortgages outweigh the benefits. “I don’t think balloon notes should be granted on owner-occupied residences,” Mazzara says. “I think that they would be solely for a savvy real estate investor that understands how to move through the market and is comfortable with the terms within the 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 some cases, borrowers who have the funds to make the payment may wish to invest the money or use it elsewhere until the balloon note payment is due. In this case, taking on a balloon mortgage is less risky because you already have the money for the lump-sum payment.
You’re expecting a lump sum before the balloon payment is due
A balloon mortgage could make sense if you’re expecting an inheritance, bonus or other lump sum and will be able to afford the balloon payment when it comes due.
You’re expecting an income increase
Borrowers who expect a significant income increase in the near future may leverage a balloon loan to purchase a home while their income is low. For example, if you work in a profession where your income is low in the first few years but will increase significantly, a balloon mortgage can get you into a home without waiting.
You’re 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 could make sense for homeowners who plan to own the property for a short amount of time and sell it before the lump sum is due. However, if the home’s value decreases during that time, you may have to make up the difference between what you sell the property for and what you owe on the loan.
Balloon mortgage alternatives
If a balloon mortgage isn’t the best fit for you, here are some alternatives to consider.
Historically, people who wanted to finance a newly constructed home had to obtain interim construction financing from a bank. But lenders now can issue one-time construction loans.
These loans typically begin as interest-only loans during the construction phase and convert to mortgages with principal and interest payments once the construction phase ends. This option can provide a safer alternative to a loan with a balloon payment.
An adjustable-rate mortgage (ARM) can provide some of the same benefits as a balloon loan, but with different risks. ARMs typically carry lower interest rates and monthly payments at the start of the loan. And homebuyers can usually qualify for a larger mortgage when they first buy a home.
But unlike balloon loans, the entire balance of an ARM doesn’t come due at once. Instead, the interest rate and payments adjust throughout the loan term after an initial fixed period.
You can ask your lender to estimate the highest payment you might face under the ARM to decide if the initial savings is worth the risk.
FHA graduated payment mortgages
Under a graduated payment mortgage backed by the Federal Housing Administration (FHA), homebuyers will see their payment increase over several years. These loans are ideal for people who want to buy a house today but can’t afford the payments on their own. The loan program is a safe alternative to balloon mortgages because it has built-in features that help ensure borrowers can afford the new payments as they increase.
A mortgage with a longer term, such as 40 years, will have a lower payment compared to a loan that is amortized over a shorter time. So this can be a more stable alternative to a balloon loan. However, you may pay more interest over the loan’s lifetime since you’ll be making payments over a longer period. Additionally, interest rates are typically higher compared to loans with shorter terms.