What is a Balloon Mortgage?
A balloon mortgage is a loan product that requires a larger-than-usual, one-time payment at the end of its term. Because you make one larger "balloon" payment toward the end, it's possible to enjoy years of lower monthly payments toward the beginning of the loan.
While it might seem unnatural to choose a mortgage with a large payment due at the end, balloon mortgages benefit consumers in more than one way. For some, the affordability of the initial monthly payments on their loan is paramount – even if they need to pay more at the end of their loan. Then again, there are plenty of other reasons families choose this unique repayment option when they purchase a home. Keep reading to learn more about balloon mortgages, how they work, and who they are good for.
Types of Balloon Mortgages
While all balloon mortgages have a large payment due toward the end of the loan term, the repayment terms that lead up to the end can vary. Here are a few different types of balloon mortgages, along with their benefits and drawbacks:
5, 7, or 10-Year Balloon Mortgage
With a short-term balloon mortgage, homeowners can make smaller monthly payments for several years before owing the full balance of the mortgage in the end. Instead of spreading the payments out over 30 years, these mortgages last for a shorter length of time.
- Pros: With a short-term balloon mortgage, homeowners can enjoy low monthly payments for years. Balloon mortgages also offer lower interest rates than most traditional mortgages, making them a smart deal for people who need to save money in the short-term.
- Cons: If you can't pay off the balance of your home at the end of your mortgage's term, you could face financial consequences and even foreclosure. Make sure you have a plan to refinance your home, move, or repay your full loan before the term of your balloon mortgage is up.
Interest-Only Balloon Mortgage
Some balloon mortgages offer an interest-only option where the homeowner only pays the accrued interest on their loan for several years. This can be a huge advantage for consumers since these loans offer lower monthly payments.
- Pros: Interest-only balloon mortgages make it possible for homeowners to secure affordable monthly payments. They tend to cost less than other loans upfront since they only require the payment of interest and not the principal.
- Cons: Interest-only balloon loans may help you afford your home payment, but they don't help you pay off the loan. When you pay interest only, you don't have the chance to deplete your loan's balance. And if you don't come up with a plan before your balloon payment is due, you'll owe the full balance of your home loan. Also, if your home's value decreases during the interest-only period, you'll wind up owing more than your home is worth by the time your balloon payment is due.
Who is a Balloon Mortgage Right For?
You may be wondering what type of person would choose a balloon mortgage. While these loans do offer unique repayment terms, there are plenty of instances where a balloon mortgage makes a ton of sense. A balloon mortgage is often a good choice for:
- Families on the verge of earning a higher income – Just because you're earning less now doesn't mean you're stuck with a lower income forever. For families with one earner on the verge of graduating from college or beginning a career, a balloon mortgage with lower payments upfront can make sense.
- Anyone who plans to move and sell their home within a few years- Since balloon mortgages offer lower interest rates than traditional mortgages, they can be a smart option for families who plan to sell their homes within a few years. They can enjoy lower payments on the front-end without having to worry about repaying the balloon payment down the line.
- Consumers who plan to refinance in the near future- If you plan to refinance your home in a few years, a balloon mortgage can make sense. By taking advantage of lower rates upfront, you can save money until you refinance into a loan that works better in the long-term.
Alternatives to the Balloon Mortgage
While balloon mortgages have their place, there are plenty of other loan options to consider. The most popular types are fixed-rate mortgages and adjustable-rate mortgages, or ARMs. Either type can help families purchase the home of their dreams, but there are advantages and disadvantages to consider as well.
Fixed rate mortgages tend to work best for families who plan to stay in their homes for the long run. With a fixed-rate mortgage, you'll lock in a steady interest rate and payment for 10-30 years.
The payment should stay approximately the same (with small changes based on taxes and insurance) and the payments are spread out evenly over the rate of the term. These loans are ideal for people who plan to stay in their homes and want a reliable payment they can count on.
Adjustable-rate mortgages, or ARMs, come with an adjustable rate that resets after a specific length of time. With a 7/1 ARM, for example, consumers enjoy a low, fixed interest rate for the first seven years, then see their rate reset for the remainder of their loan. The adjustable rate of their loan is tied to an index such as the LIBOR, or the London Interbank Offered Rate.
Adjustable-rate mortgages can be smart for consumers who want to enjoy low monthly payments early on, then potentially refinance down the road. They can also work for consumers who want to save money on payments for a few years before selling their homes.
Should I Get a Balloon Mortgage?
If you're considering a balloon mortgage, you need to consider your goals. Are you hoping to get the lowest payment possible now, then refinance or sell in the future? Do you expect your income to increase tremendously over the next few years? If so, a balloon mortgage could be right for you.
On the flip side, balloon mortgages come with plenty of risks as well. If you can't refinance or sell your home, you'll be on the hook for the final balloon payment, regardless of your financial situation. Before you choose a balloon mortgage for your home purchase, make sure you weigh the pros and cons and consider potential alternatives.