A “balloon mortgage” is a home loan that does not fully amortize over the life of the loan, leaving a large balance at the end of the shortened term.
As a result, the final payment on a balloon mortgage will be significantly larger than the regular monthly mortgage payments.
Let’s look at a quick example of a balloon mortgage:
7-Year Balloon Mortgage
Interest Rate: 5.00%
Amortization: 30 Years
Loan Amount: $250,000
In the above scenario, the monthly mortgage payment would be $1,342.05 per month, which is the standard 30-year fully-amortizing payment, for the first seven years, with a remaining balance of $221,204.98 leftover at the end.
The remaining balance is the balloon mortgage payment that is due in full after seven years. It probably sounds like a lot of money to pay (it is!), but as mentioned earlier, most borrowers either refinance or sell before it gets to that point. They usually have no other choice.
The ING Easy Orange Mortgage was an example of a balloon payment first mortgage that was freely available to homeowners nationwide.
Seconds mortgages may also be balloon mortgages, a common one being the “30 due in 15.” It amortizes like a 30-year mortgage, but full repayment is due in just 15 years. Again, most borrowers either pay it off, refinance, or sell before the term ends.
Advantages of Balloon Mortgages
Well, balloon mortgages rates should come at a discount to fixed-rate loan and ARM rates, making them a cheaper alternative.
And if you don’t plan on staying in the home or with the loan for more than a few years, it could prove to be the right choice for you.
Of course, the big tradeoff is the associated risk if you get stuck holding the bag.
Disadvantages of Balloon Mortgages
The clear disadvantage to a balloon mortgage is the uncertainty at the end of the loan term.
For example, after seven years, the entire loan balance is due. No ifs, ands, or buts about it.
This isn’t the case with a fixed-rate loan or an ARM.
Fixed-rate mortgages have the same payment throughout the life of the loan, while ARMs may adjust higher or lower, as determined by their caps.
Those caps will limit the amount the mortgage payment can rise, providing some level of protection and an early warning system, so to speak.
Sure you could be underwater on your loan (owe more on mortgage than home is worth), but the payments would likely stay manageable thanks to the caps.
Balloon Mortgages vs. Adjustable-Rate Mortgages
A balloon mortgage differs from an adjustable-rate mortgage because full payment is required at the end of the shortened loan term.
With ARMs, the loan simply becomes adjustable after the initial fixed-rate period ends, but isn’t due in full immediately.
It continues to amortize on a 30-year schedule, though mortgage payments can fluctuate based on the variable interest rate.
In conclusion, be sure to compare all your options – you may be surprised to find that a fixed-rate loan prices better than an ARM or a balloon mortgage, without all that risk!
Update: When the Qualified Mortgage (QM) rule was introduced by the Consumer Financial Protection Bureau (CFPB), balloon mortgages were largely outlawed. That should give you an idea about what consumer advocates think about these types of loans.