What is a balloon mortgage?
A balloon mortgage is a short-term loan that offers lower monthly payments (and usually a lower interest rate) than a traditional fixed-rate mortgage because it’s not fully paid off at maturity. It’s so named because, at the end of the loan term, your monthly payment “balloons” to include payment of the outstanding principal.
Most balloon mortgages have a term of either five or seven years but are amortized over 30 years. In other words, the amount of your monthly payment is based upon a schedule that would require you to make continuous monthly payments for 30 years in order to pay off the loan. But, because the term of the loan is so much shorter than this, you are left owing an outstanding balance. Usually, this amount must be paid off through refinancing the loan or selling your home. For example:
Term: 5-year balloon mortgage
Interest rate: 6.5%
Monthly payment: $1,264.14
Remaining balance at end of 5-year term: $187,222
Term: 30-year fixed-rate mortgage
Interest rate: 7%*
Monthly payment: $1,330.60
Remaining balance at end of 30-year term: Nil
*In this example, the 30-year fixed-rate mortgage has an interest rate .5% higher. Actual interest rates will vary.
Because a balloon mortgage does very little to pay down your principal, it’s not an effective way to build equity in your home. It also may not be the best solution if you plan to stay in your home and refinance to a traditional mortgage at the end of its term, as this will likely result in a sudden increase in your monthly payments. If you are unable to afford the higher payments, you may be forced to sell your home or risk foreclosure.
Some balloon mortgages also offer a conversion/reset option that enables you to extend the term of the mortgage at the current interest rate. This may, however, involve re-qualifying if interest rates have risen substantially since you first took out the loan.
You may benefit from a balloon mortgage if:
- You’re planning to sell your home before the loan matures and want a relatively low monthly payment until that time.
- You’re expecting a significant improvement in your finances that will enable you to pay off a good chunk of the loan at maturity.
You should probably avoid a balloon mortgage if:
- You are planning to remain in your home and may find it difficult to make higher monthly payments when you refinance the loan.
- You are concerned that rising interest rates may increase the cost of the loan significantly when it comes time to refinance.