Balloon mortgages typically have shorter terms and higher interest rates than traditional mortgages. They require a lump-sum payment at the end, and they’re usually harder to qualify for. In spite of all this, some borrowers find them appealing because they can mean lower monthly payments. Should you consider getting one? If not, what are some alternatives?
When you finance a home purchase using a balloon mortgage, you agree to finish paying off your home loan with a lump sum when the loan ends. Instead of paying enough principal each month to zero out your debt over the term of your mortgage, you shift much of the principal to the future. The result is a balance due at the end of your loan. To avoid foreclosure and loss of your property, you have to cover this outstanding balance with a balloon (lump-sum) payment.
Is the reduction in near-term expense worth the end-of-loan risk posed by a balloon mortgage? When might a balloon mortgage be a sensible option? When is it a bad idea? Could it be right for you? If not, what are some alternatives?
Read on to learn more.
What is a balloon mortgage?
People buying homes and land most commonly get the funds they need using a mortgage. A mortgage agreement gives the lender a security interest in the real property being financed. In other words, it makes the property collateral for the loan. This leads to a lien against the property that won’t go away until the loan’s been paid in full. Borrowers who default on their mortgage loans should expect foreclosure and loss of their property.
A balloon payment could mean low monthly payments
One type of mortgage loan is a balloon mortgage. It’s called a “balloon” mortgage because there’s a large, potentially very large, payment due at the end. Prior to that, monthly payments may be smaller than those for more common types of home loans. This depends on the loan term, however. Monthly payments for a 20-year balloon loan will be lower than those those for a 20-year standard mortgage, almost certainly, but balloon loan terms tend to be shorter than this, and standard mortgage terms may be longer.
So it isn’t the case that every balloon mortgage will have lower monthly payments than every traditional mortgage. Still, lowering monthly payments is what motivates most borrowers to consider mortgages with balloon payments. Low monthly payments are balloon loans’ main selling feature.
Balloon loan payments and terms vary
The lump-sum payment at the end will typically be more than twice what the borrower pays every month before then. As for the monthly payments prior to that, those might cover interest only, in which case the borrower will owe a lump-sum payment equal to the home’s full purchase price. More commonly, the monthly payment will pay a little principal in addition to interest, just not enough to zero-out the balance due before the balloon payment is due.
How does a balloon mortgage work?
If you know some accounting, you may already realize that a defining characteristic of balloon mortgages is that they are not fully amortized. Descended from the Latin for “to kill,” amortize means to pay off (“kill”) your loan balance over time.
Balloon-payment mortgage vs. other mortgages
With an FHA, VA, USDA, or conventional mortgage, paying off the loan balance means making monthly payments over, say, 15 or 30 years. The monthly mortgage payments, which pay both interest and principal, are set by an amortization schedule that will take the balance due down to $0 over the loan term. Because the scheduled payments will zero-out the loan, such loans are said to be fully amortized.
Balloon mortgages are a different matter.
Balloon mortgage terms
Five and 10 year terms may be most common, but borrowers like homebuilders may take loans with terms of less than two years.
Balloon mortgage payments
Balloon mortgages’ monthly payments might cover only interest, in which case the loan principal isn’t amortized. More often, it will be partly amortized, meaning you will pay some principal, but not all of it, during the loan term.
As for the balloon payment, when it comes due at the end of the term, your unpaid principal will determine just how big that final payment has to be. This is assuming you don’t sell or refinance before then, which is what many balloon loan borrowers have planned when they take out these loans.
A balloon mortgage lets you put off all or a portion of your principal payments to the end of the loan. On the positive side, this results in lower monthly payments than those for a fully amortized loan of equal duration. On the negative side, you have to pay off all that outstanding principal when your loan reaches term.
What would my payment schedule look like?
As you’ve seen, the basic workings of balloon loans are straightforward. If you were to buy a home with a conventional 30-year mortgage but decide to pay it off after 10 years because of an unexpected large inheritance or the like, how would your experience differ from just getting a 10-year balloon mortgage in the first place? Assuming your mortgage agreement did not impose a prepayment penalty for paying everything off after 10 years, and assuming equal monthly payments and matching APRs, not a lot.
Comparing standard and balloon mortgage schedules
To get a better idea how this all works, let’s test some sample figures. Let’s compare schedules for the following: interest-only payments with a concluding balloon payment, interest-and-principal payments with a final balloon payment, and a fully amortized mortgage. For ease of comparison, we’ll assume a $250,000 loan with a 5% annual percentage rate (APR) in each case. We’ll also assume a fixed APR.
Now, keep in mind that a detailed amortization schedule for a mortgage with a loan term of just five years would require 60 rows for the monthly payments. And it would be profoundly boring to read. So, to make the examples easier to take in, we’ll present yearly rather than monthly totals.
Also keep in mind that online mortgage calculators, including the one we’ve used for these examples, leave out various costs you can expect to pay when you finance a home. These simplified examples will only give you a general idea of what to expect if you get a balloon mortgage.
30-year fixed-rate mortgage schedule
To set up our comparison, let’s first look at a standard 30-year mortgage. For a loan amount of $250,000, your monthly payment will be $1,342.05. That’s what you’ll pay every month for 30 years, except for the last month (month 360), when you’ll need to pay $1,345.33 to zero out the remaining loan balance.
Each month, the portion of your payment that goes toward principal will rise while the portion going toward interest drops. For instance, in month one you’ll only pay $300.38 in principal. But in month 359, the same size monthly payment will cover $1,330.92 in principal.
Here’s what the yearly totals look like for this mortgage:
At the end of this 30-year process, you will have paid $233,141.28 in interest and $250,000.00 in principal. Everything’s been paid off, so you have no outstanding balance.
For this and the next example, we’ll assume the same $250,000 loan amount, the same 5% fixed APR, and a 10-year term.
As hypotheticals go, the interest-only example isn’t very exciting. 5% of $250,000 is $12,500.
That’s your yearly interest. Dividing that into equal payments over 12 months gives you a monthly payment of $1,041.67. (Technically, this monthly payment will put you four cents over $12,500 each year. So feel free to pay four cents less every December.)
|Year||Payments made||Interest paid||Principal paid||Remaining balance|
At the end of this 10-year process, you will have paid $125,000.00 in interest and $0 in principal. You still owe the full $250,000 in principal, so your monthly payments have just let you put off paying for the house for 10 years.
Schedule with principal payments
If you’d rather pay down the principal some before the balloon payment comes due, you could opt for a 10-year balloon mortgage with the same monthly payment as the 30-year standard mortgage.
At the same loan amount and APR, this 10-year balloon mortgage will cost you $1,342.05 a month, $16,104.60 a year, and $161,046.00 over the course of the loan. After paying all this money, you’ll be left with a remaining balance of $203,355.80.
Here’s what the yearly figures look like for this loan:
|Year||Payments made||Interest paid||Principal paid||Remaining balance|
These figures look uncannily like the figures for the 30-year standard mortgage, just with the last 20 years removed. If you could qualify for either loan, you might see no reason to consider the balloon mortgage.
If you need an even lower monthly payment, however, you could opt to pay off less principal with a balloon loan. In essence, you could arrange monthly payments equivalent to what you’d pay for a fully amortized loan with a term greater than 30 years. Of course, this would mean building up less equity and owing a bigger balloon payment.
How do balloon loans differ from other loans?
In the real world, you’re unlikely to find yourself choosing between standard and balloon mortgages with matching APRs and payments. Having a big balloon payment due at the end isn’t the only thing that distinguishes balloon mortgages from other types of home loans. They also differ in other ways, such as the following.
Mortgages that meet certain requirements that make them more stable, meaning that people who qualify for them probably won’t default, are called qualified mortgages. These requirements include avoidance of such risky loan features as interest-only payments, balloon payments, and terms longer than 30 years.
Since large lenders typically ensure the financial viability of their offerings by complying with the qualified-mortgage rules, balloon mortgage lenders tend to be smaller or private. Some larger lending institutions may offer balloon mortgages for special purposes, such as construction financing, since the borrower profile and risks differ in those circumstances.
Requirement to qualify differ
Since balloon loans are not qualified mortgages, lenders consider them more risky. They usually compensate for this by making it harder for borrowers to qualify. To get a balloon mortgage, you may need a higher credit score or a larger down payment, for example.
Interest rates differ
Another thing that balloon mortgage lenders often do is charge higher interest rates. This is another way that they compensate for the added risk of these loans. So be prepared for a higher APR if you pursue a balloon mortgage.
Balloon mortgages for business
Who might want to get a mortgage like this? Well, if you’re a home builder or house flipper, you might consider it. After all, if you do your job right, the property will soon be worth a lot more than what you paid for it. Why lock yourself into something more than short term when you’ll soon have a more valuable property to bargain with?
An interest-only loan should be especially appealing to such businesses. Why pay more each month than just interest if you’re planning to sell the property as quickly as possible? If your development stalls or the real estate market tanks before you can sell your flip, you can always refinance.
Balloon mortgages for builders
It’s no surprise, then, that balloon mortgages do appeal to such businesses as homebuilders. Balloon mortgages allow builders to use the property they’re developing as their only collateral. Though more conventional business loans typically have lower interest rates than these balloon-payment loans, some developers think not having to put other property up as collateral makes them worth the higher rates.
Balloon mortgages for flippers
House flippers can favor these loans for the same reason. Think about it. Do you want to get a second mortgage on the home you live in to fund your purchase of a property to flip? Or would you rather get a mortgage on just the property you’re flipping? If the flip goes badly in the first case, you could lose the home you live in. In the second case, you lose just the investment property. Neither is a good outcome, but losing just the second property is clearly less bad.
Short-term balloon for builders and flippers
Because they usually only need short-term financing, land developers and house flippers may seek balloon mortgages with terms of just a year to a year and a half. Once the property’s been developed or the house flipped, builders and real estate investors who can’t sell immediately can qualify for lower-APR loans of larger amounts due to the new, higher value of their property.
Should I get a balloon mortgage?
You now know the basic features of balloon mortgages, how they differ from more traditional alternatives, and why they might appeal to such borrowers as homebuilders and house flippers. Should you consider a balloon mortgage? One way to decide is to carefully consider the pros and cons, the benefits and risks, involved. Let’s review those now.
Consider these pros and cons before getting a balloon mortgage
- Ability to buy a property sooner. If you know you will have a considerably higher income in the future than what you have now, committing to a lump-sum payment years from now may seem worth the risk. It might get you into a house sooner.
- Can be great for house flipping. Balloon mortgages include so-called “fix-and-flip” loans. These are loan products designed and marketed to house flippers. They may carry higher interest rates and fees than alternatives, but they typically offer lower monthly payments. As a house flipper, reducing your monthly expenses with lower loan payments may be worth a higher APR and some extra fees.
- Possibly faster. Some providers of balloon mortgages process these loans more quickly than standard mortgage lenders.
- Potentially less paperwork. Balloon mortgages often don’t require as much documentation as standard mortgages do. Some, for instance, won’t require getting the property appraised. Paperwork will vary from loan to loan and lender to lender, however.
- Lower monthly payments than some fully amortized alternatives. An interest-only balloon mortgage will usually have lower payments than a standard mortgage. A partially amortized balloon mortgage may have lower payments than such fully amortized alternatives as a 15-year mortgage. As a rule, the closer you get to paying interest only (the less principal you pay), the lower your monthly payments will be.
- You may build equity more slowly. As we saw above, a balloon mortgage could differ from a 30-year mortgage only in its duration. In such a case, you would build up just as much equity each year as you would with the traditional 30-year mortgage. Often, however, balloon mortgages will build equity more slowly. For instance, if your reason for accepting a balloon mortgage is to get lower payments than you could get with a mortgage amortized over a 30-year term, that lower monthly payment will probably mean building equity more slowly, since it’s unlikely the lower payment will be due to a lower APR.
- Higher interest rates likely. Qualified mortgages have lower interest rates because there is less risk that approved borrowers will default. Balloon mortgages are not qualified mortgages. As higher-risk loans, they typically have higher APRs.
- May be harder to qualify for. Because the risk of default for these loans is higher, balloon mortgage providers often require a larger down payment and higher credit score to qualify.
- Risk of foreclosure and home loss. This is a risk with every mortgage loan, of course. But the balloon-payment requirement makes foreclosure an especially high risk with this type of loan.
- Risk you’ll need to borrow more. Many balloon-mortgage borrowers plan all along to refinance rather than make the balloon payment. But taking out a new loan to pay off an old one, as you might have to do to cover a balloon payment, isn’t guaranteed to work. For example, what happens if you can’t get approved for refinancing when you need it?
Balloon mortgages for special cases
Under the right circumstances, balloon mortgages can be a sensible choice for certain businesses, as we saw earlier. If you’re a real estate investor who flips houses or a builder, balloon mortgages could be a sensible way to get the financing you need.
Here are some other circumstances where a balloon mortgage could make sense:
- You are confident funds to cover the balloon payment will come your way before it’s due. Many people think they can count on future contingencies like inheritances, bonuses, personal injury settlements, and rising incomes. If you’re one of those people, you may decide a balloon mortgage makes sense.
- There is good reason to expect you’ll sell the house before the balloon payment comes due, and you’re pretty sure that housing prices won’t drop. This is another case of being sufficiently confident about the future that certain risks today don’t seem so bad. Perhaps you’re planning to live in the house for a short time, just long enough to fix it up for resale, and you think a drop in housing prices too remote a possibility to worry about. For you, a balloon mortgage might make sense.
- You could pay cash for the property but have more productive things to do with the money for the next several years. If you have enough money on hand to pay the lump sum you’re agreeing to, you may consider a balloon mortgage a reasonable way to keep your funds liquid. You’re expressing confidence that you won’t lose that money between now and when the lump-sum payment comes due.
The common thread in these special cases is confidence about the future. If your experience with future contingencies resembles this writer’s, you won’t feel inclined to take out a risky loan based on such expectations. However, if you’ve gambled on future contingencies before and it’s paid off, you might be more tempted.
If you do decide to take a chance based on something you think will happen in the future, try to make sure your expectations are justified by a sober assessment of the facts. Wishful thinking and an optimistic temperament are no substitute for financial prudence.
Balloon mortgages allow borrowers to move a portion of the principal they’d normally pay in monthly installments to the end of their home loan. Interest-only balloon mortgages allow these borrowers to move all their principal payments to loan’s end. These loans can be harder to qualify for and typically have higher interest rates. Are they a good idea?
Balloon mortgages reduce the investment value of homeownership
For average homebuyers, probably not. Average mortgage borrowers are financing the biggest investment they will ever make. Through wise money management over 15 to 30 years, they can build up equity in their homes. Since real estate values tend to rise over time, excepting occasional drops after market overheating, the equity owners accrue over time typically exceeds their principal payments, providing a better rate of return than many other investments.
Balloon mortgages attenuate this wealth-building effect of homeownership. Though balloon loans can reduce how much borrowers have to pay every month, this comes at a high price. Borrowers end up paying more in interest and less in principal. As a result, they build less equity. And they have to pay a large amount of cash all at once at the end of their loan.
Average buyers vs. business buyers
In most cases, average homebuyers who can’t afford to make the payments on a fully amortized 30-year mortgage should probably look for a cheaper property or delay buying a home. If you gamble on a balloon loan and fail to pay it off, you could lose your home and ruin your credit.
For the most part, only businesspeople who need short-term financing for real estate development or rehab should consider balloon mortgages. These mortgages, particularly the interest-only variety, can be a great way to finance lucrative real estate investments while minimizing monthly costs. These arrangements can be risky, of course, but business is all about taking calculated risks. If you are a builder or house flipper, you may find balloon mortgages a risk worth taking.
How can I pay off a balloon loan?
What if you already have one of these mortgages? How can you pay it off so you don’t default on your loan or lose the property? Here are some options.
Saving for your payment
One thing you need to do is make sure you’re saving up for your balloon payment. This isn’t something you can put off thinking about until later. To get started, read our comprehensive guide to saving money.
Paying more when you can
If your balloon mortgage doesn’t impose a penalty for early payment, consider paying extra whenever you can. This will reduce how much you have to pay in that final lump sum.
Another option is to refinance before you have to make your balloon payment. If you’re happy with the monthly payments you’re making now, you may be tempted to put off looking into your refinancing options.
This could be a mistake. If you currently qualify for a more traditional mortgage and could handle the required payments, why put it off? How much equity are you accumulating with your current mortgage? Could you start accumulating more by refinancing?
If you’re not sure, take some time to review our article detailing the pros and cons of mortgage refinancing.
Sell the property
If you find the balloon payment approaching and fear you won’t be able to cover it, it may be time to put your home up for sale.
Borrow from other lenders
Another option is to investigate other funding sources. Could you qualify for a personal loan to help cover your balloon payment? Do you have friends and relatives who could loan you money. This isn’t an ideal solution, but if your only alternative is defaulting on your mortgage, it could be worth considering.
Get your loan extended
Balloon borrowers can sometimes negotiate extensions to put off having to make the balloon payment. Such extensions often mean added fees and may not add much time, but this option may be worth considering if you’ve run out of alternatives.
Balloon mortgage alternatives
Here are a few alternatives to balloon-payment mortgages to consider.
Mortgages with extra long terms
As you saw above, balloon loans can resemble traditional mortgages that you pay off early in a lump sum. The only way to get the monthly payments even lower is to reduce the amount of principal paid each month. Assuming you still pay some principal, the balloon mortgage still resembles a longer-term mortgage you pay off early, but it now resembles a mortgage with an unusually long term.
So why not see if you can just arrange a fully amortized mortgage with such a long term? If you can arrange a mortgage with a 40 or 50 year term, that could reduce the the monthly payment just as much as the balloon-payment arrangement.
Since a loan with this longer term will not pass the qualified-mortgage test, you’ll probably pay a higher interest rate than you would for a traditional 15- or 30-year mortgage. And, since the loan’s amortized over a longer period, you’ll pay more in interest even if you land the same APR.
Mortgages with adjustable rates
Adjustable-rate mortgages (ARMs) are another alternative to balloon-payment mortgages. ARMs usually start out with lower APRs and lower monthly payments.
Borrowers can usually get approved for larger mortgages with an ARM. ARMs typically begin with a fixed period during which the monthly payment does not change. This payment will usually be lower than the monthly payment on a traditional fixed-rate mortgage.
After the initial fixed period, an ARM’s APR and monthly payment vary, rising or falling depending on the broader market as measured by a benchmark rate, such as the prime rate.
As you can imagine, ARMs pose significant risk should market rates rise. Caps on how much and how quickly ARM rates can change usually reduce this risk. Before you agree to an ARM, make sure your lender explains in detail what caps will apply to your arrangement and what that means for your monthly payment after the fixed-rate period. Your lender should give you an estimate of the highest monthly payment you could end up having to cover in both the most likely and worst-case scenarios.
FHA graduated-payment mortgages
The Federal Housing Administration (FHA) backs mortgages with graduated payments. With one of these mortgages, the borrower’s monthly payment increases over a number of years.
Like balloon mortgages, graduated-payment mortgages are designed for borrowers who will have more money in the future than they have now. Unlike balloon mortgages, FHA graduated-payment mortgages have features meant to make borrower default less likely. They do this by tying changes in payments to borrowers’ ability to pay.
Tailored construction loans
Lenders now offer loan products tailored to the needs of builders. These can be a good alternative to balloon-payment arrangements. Often called “construction-to-permanent” loans, these loans are just that. Usually beginning as interest-only arrangements, these loans convert to amortized mortgages when construction’s completed.
In essence, these special loans take care of the refinancing arrangements in advance. Rather than having to worry about qualifying for a new loan after completing construction, builders who arrange one of these tailored mortgages set up everything in advance. Reducing the risk and uncertainty that come with a balloon-payment arrangement, these loans appeal to many builders.
Frequently Asked Questions about balloon mortgages
What happens when a balloon mortgage is due?
When a balloon mortgage comes due, you must pay the remaining principal in a lump sum. In the case of an interest-only mortgage, this will mean the entire purchase price of the home.
Can I sell my home with a balloon mortgage?
Yes. This, in fact, is one way you can avoid having to make the balloon payment out of pocket. As long as the property is worth more than the lump-sum amount, you should be good to go.
What happens if you can’t pay a balloon payment?
If you can’t pay the balloon payment, can’t arrange a loan extension or refinance, and can’t sell the home to cover the payment, you’ll face the same consequences as anyone who defaults on a mortgage: foreclosure and the loss of your property.
What happens at the end of a balloon loan?
At the end of this type of loan, you will have to make the lump-sum payment you agreed to when you signed your mortgage paperwork. If you fear this will be a problem, consider refinancing or selling your home before then.
Can you refinance a balloon payment?
Yes, if you can qualify. Refinancing your way into a traditional mortgage is well worth considering if making the balloon payment will be too much of a hardship.
Will my interest rates be higher or lower with a balloon mortgage?
Usually higher. Lenders consider these loans higher risk. One way they adjust for the added risk is by raising the APR.
- Balloon mortgages usually have shorter terms and higher APRs than traditional home loans.
- Balloon mortgages shrink the size of monthly payments by reducing how much of each payment goes toward principal.
- Interest-only balloon mortgages include all the principal in the final payment.
- The final payment to settle a balloon mortgage is called a balloon payment or lump-sum payment.
- If you want to build equity in your home as quickly as possible, a balloon mortgage probably isn’t for you.
- Prudent homebuyers will carefully consider all alternatives before committing to a balloon-payment mortgage. Very often, a cost-benefit analysis we reveal that an alternative is the better choice.
- Balloon mortgages can be risky. When you commit to paying a large lump sum five or 10 years from now, you can easily fail to save up enough money in time.
- There are certain situations where a balloon mortgage can be a sensible choice — not necessarily the only or best choice, but one acceptable possibility among others.
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