What is a balloon mortgage?
Updated April 27, 2022
Initially, a balloon mortgage likely has fixed, low monthly payments––although some balloon loans have variable interest rates––with the total balance due in a "balloon payment" once the loan matures. This final payment due at the end of the term is an amount significantly higher than the previous monthly payments.
The terms and maturity times of a balloon mortgage can vary depending on the lender, but most terms are about five to seven years. Some balloon mortgages have a reset period where the interest rate resets every so many years, aligning the loan with current interest rates.
A balloon mortgage has lower monthly payments throughout the course of the loan, but ends with a higher final payment. Credit: Peggy und Marco Lachmann-Anke/Pixabay
Although there are some immediate advantages to a balloon mortgage, it presents more risk than most other loan products over the long term.
Advantages of a balloon mortgage
A balloon mortgage generally involves a lower interest rate than a fixed or adjustable-rate mortgage. Like other mortgages, the rate depends upon market conditions and the borrower's credit rating. Lower monthly payments could permit the borrower to purchase a more expensive home, affording more space perhaps, better amenities, or a house in a more desirable location.
Buyers typically aren't required to put the standard 20% down when choosing a balloon mortgage, so if someone is short on cash or prefers not to use savings to purchase a home, a balloon mortgage can be attractive.
Disadvantages of a balloon loan
A balloon loan can ruin a stellar credit rating if the borrower can't make the final payment on time.
In order to qualify for a bank refinance, the borrower would need at least 20% equity in the home. And if the property's value decreases during the life of the loan, securing a new loan will be difficult, if not impossible. Plus, if the borrower is not able to refinance the home before the due date, the property would be forced into foreclosure.
During the Great Recession, many homeowners couldn't come up with the cash to pay their balloon loans, refinance, or sell their properties before the mortgage matured.
Because home values plummeted between 2007 and 2009, many homeowners chose to walk away from their properties as they owed more than what their homes were worth. There was no logical way to recover for someone whose $300K balloon loan was due, but their house was worth just $225K. No bank would grant a loan for a home with negative equity. The homes went into foreclosure.
When is a balloon mortgage a good idea?
Someone may benefit from a balloon mortgage under these conditions:
- When a homeowner expects to sell the home after a short time, before the loan matures and the balloon payment is due.
- Interest rates are supposed to drop and the homeowner plans to refinance before the loan matures.
- When the buyer anticipates a higher income by the time the balloon payment is due and they can make the balloon payment without issue.
- When most of the buyer's income is paid in one lump sum, such as an annual bonus at year's end, that money can offset the balloon mortgage's final payment.
Alternatives to paying off a balloon mortgage:
If you have 20% equity in your home, you may be able to refinance into a conventional loan. If not, the other option is to generate enough cash as a down payment to increase the equity. A lender will review your debt-to-income ratio, credit score, and history before determining if you're eligible to refinance.
If refinancing isn't an option, you can sell the house. But, if the property value has decreased and you owe more than the house is worth, you'll be responsible for paying the remainder of the balloon loan after the home has been sold.
If selling and refinancing are off the table, a lender may be able to change the loan terms to lower the interest rate, place the loan in forbearance so principal payments are on hold for a period, or extend the loan’s terms. Inquire with your bank.
Where to find a balloon mortgage
Balloon loans were popular before the 2008-2009 financial crisis. These days, fewer banks offer this product, so securing a balloon loan for a residential property may prove challenging. These high-risk loans are granted more frequently for commercial real estate.