Balloon mortgages are a rare beast in the field of mortgage loans, but they are an important contrast to the once-popular ARM or an interest only mortgage. This mortgage offers loan rates substantially lower than the norm and may be the perfect fit for real estate investors or anyone who expects to refinance soon.
How do Balloon Mortgages Work?
A balloon mortgage is a home loan which has regular payments for a short period of time and terminates with a "balloon" payment when the bulk of the loan must be repaid. A typical loan of this type might be a five- or seven-year mortgage, amortized over a thirty-year term at appropriate mortgage loan rates. Although the mortgage rate and payments are such that the owner would pay the loan off in thirty years, the remainder of the mortgage is due at the end of the prearranged term.
The appeal of balloon mortgages lies in the loan rates that are available for this type of mortgage, which can be much lower than those available for other types of home loans.
These mortgages often come with the option of a "two-step plan" or "reset option" which enables the homeowner to extend the loan by another term, at the current mortgage loan rates. They may have fixed or variable interest rates, and a balloon mortgage payments calculator will often indicate huge savings compared to a normal fixed or variable rate mortgage.
Balloon Mortgage vs. ARM
Many home buyers might consider a balloon or an adjustable rate mortgage (commonly known as an "ARM") in the same circumstances, although they have several important differences:
- Whereas an ARM will adjust to a higher interest rate – and higher payments – after the initial period of the loan, a balloon mortgage is due and must be paid in full after its short initial term.
- There is no general down payment rule when it comes to securing an ARM, but balloon mortgages typically require at least 25% of the house's value down.
- It's possible to secure a better mortgage loan rate for balloon mortgages than for comparable ARMs – anywhere from 0.125% to 0.7% lower than an ARM from the same institution.
- Both can incur high refinance costs when a homeowner might wish to change over to a more standard mortgage – but most ARMs will have additional closing costs that can be extortionately high, whereas balloon mortgages come to the end of their term without additional fees being charged to pay off the loan.
- An ARM may have a much shorter initial period (one to seven years) than the term of the average balloon (usually either five or seven years).
Who Uses Balloon Mortgages?
This type of mortgage can be a nightmare for some homeowners, but are useful in certain circumstances:
- A real estate investor who is planning to resell the home before the balloon payment is due
- A homeowner who intends to refinance the mortgage in the next few years to pay for a kitchen remodel or other financial need
If the home buyer is planning to get rid of the mortgage in a few years, the lower interest rates available with balloon mortgages will save money. For someone with a steady, regular income and good credit, this type of loan isn't a problem – it's only if circumstances change that this mortgage can spell trouble.
Reference
Brown, Jeff, "Why a Balloon Mortgage is the Sasquatch of Loans," BankingMyWay.com, 2009.
Guttentag, Jack, "Is a Balloon Loan Better Than an Adjustable Rate Mortgage?" MtgProfessor.com, 20 November 2008.
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