What is a balloon payment on a mortgage?

House with a for sale signA balloon mortgage is a loan with a short payoff date, usually 5 or 7 years, but the monthly loan payment is calculated on a longer term, usually 15 or 30 years. The loan is said to balloon after the 5 or 7 year term; the entire loan amount is required to be paid off in full. This is known as a balloon payment.

With a 15 or 30 year fixed rate mortgage the loan amount is paid back to the lender over a 15 or 30 year time period . . . with interest. The monthly balloon mortgage payment is calculated in the same way as a 30 year fixed rate mortgage, in most balloon mortgage plans. If the interest rate and loan amount is the same, the monthly loan payment will be the same. The difference of course is that after 5 or 7 years, the entire balance must be paid off.

So why would anybody want a balloon mortgage? There can be any number of reasons for a balloon mortgage. The primary reason home buyers and homeowners take a balloon mortgage is because the interest rate is lower than a 30 year (or 15 year) interest rate. The lender is happy to offer a lower interest rate to borrowers who take out a balloon mortgage because the bulk of the loan will be paid off in it's entirety within a few years. The lower interest rate can enable a home buyer to purchase a more expensive home, or give the home buyer a lower mortgage payment than a 30 year fixed rate.

How do I payoff the balloon mortgage?

You might be thinking, so how does anybody come up with the money to pay the balloon payment? Simple. The balloon mortgage can be refinanced up to the balloon date. I know of a lender who pushed (encouraged) home buyers into balloon mortgages. The home buyers were able to finance more money and consequently, purchase more expensive homes. This tactic is beneficial when there is competition for homes. With some situations, it could be the only way to snag the ideal house. After one or two years, the lender went back to the borrower to refinance the home buyers into a 30 or 15 year mortgage. The balloon balance was paid off under the refinance.

Balloon mortgages can make sense

Balloon mortgages are ideal for the corporate transferee. If the borrower knows that he or she is going to be transferred within a few years, a balloon mortgage makes sense. Why not take a balloon mortgage on a house with a lower interest rate with the understanding that the home will be sold and the mortgage will be paid off before the loan is required to be paid off?

Borrowers who have an expectation of an inheritance or know a chunk of money is coming their way can benefit from a balloon mortgage.

Balloon mortgage reset option

Chances are, the balloon mortgage will have a rest option (make sure the lender includes this option). The balloon mortgage reset option means that the balloon mortgage will convert to a fixed rate mortgage for the remainder of the amortization period. The interest rate on the balloon mortgage will be adjusted. Read the fine print. It's possible that the new interest rate could be higher than the current market interest rate. Other conditions for the reset are required for a reset.

Alternative to a balloon mortgage

For home buyers and homeowners who are uncomfortable with the thought of a balloon payment, then a hybrid mortgage would make sense. The hybrid loan is a combination of a fixed rate for a term of 5 or 7 years and then converts to an adjustable interest rate. The benefit of course is that there is not final payment with the hybrid mortgage. The interest rate on a hybrid mortgage is usually lower than the fixed rate mortgage terms, but higher than a balloon mortgage.