What Is a Balloon Mortgage?
A balloon mortgage, also referred to as a balloon note, is a type of mortgage that does not fully amortize over the loan term. When the term has ended, the borrower must make a large principal payment to satisfy the loan.
Balloon notes are commonly used as business loans. However, in the consumer market, they’re typically associated with mortgages. These loans allow borrowers to make low monthly payments during the loan term. In some cases, the monthly payments may only cover the loan’s interest. At the end of the loan term, the borrower must pay off the remaining balance as a lump sum. This is typically done by refinancing the loan or paying it off in cash.
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How Does a Balloon Mortgage Work?
To take out a balloon mortgage, you must go through an application and underwriting process similar to applying for a traditional mortgage. Once the loan is approved, you pay monthly payments throughout the loan term. At the end of the loan term, the remaining principal balance is due to the lender.
To clarify this, let’s assume you want to take out a $500,000, 5-year balloon loan with a 5% interest rate. Here’s a look at what you might expect.
Balloon payments are non-qualified mortgages typically offered by small or private lenders. They may have stricter eligibility requirements. These may include:
- Good credit score: To qualify for a balloon loan, you typically need a good credit score, usually around 650 or higher.
- Stable income: You must have a stable and reliable source of income to show that you can make regular payments on the loan.
- Down payment: Balloon loans often require a down payment of 20% or more of the total loan amount.
- Loan term: Balloon loans typically have a shorter loan term than traditional loans, often ranging from 3 to 7 years.
- Ability to make the final payment: You must have a plan in place to make the final lump sum payment at the end of the loan term, whether it be through savings, refinancing, or selling the asset that was purchased with the loan.
Interest-Only Payment Phase
Some balloon mortgages are interest-only loans. This means that the borrower only pays the interest during the loan term, and no payments are applied to the principal balance. The lump-sum payment due at the end of the loan term is the same as the initial amount borrowed.
Continuing with the example above, a 5% interest-only payment on a five year $500,000 loan is $2,083.34 per month. After making these monthly payments for five years, you’d owe a balloon payment of $500,000.
It’s also possible for balloon loans to have a two step repayment, meaning that you pay a low-interest rate or make interest-only payments early in the loan period, then switch to a higher interest rate and larger payments after the initial borrowing period.
Balloon loans typically do not have prepayment penalties allowing you to make additional payments at any time during the loan term. By doing so, you could begin to decrease the principal balance. However, loan terms can vary, so checking with your lender to confirm whether your loan is subject to a prepayment penalty is important.
Interest and Principal Payment Phase
If your balloon mortgage is not interest only, your monthly payments will apply partially to interest and partially toward paying down the principal balance. However, monthly payments are not amortized to pay off the loan at the end of the term.
For example, assume you have taken out the balloon loan described above and are paying $3,500 monthly. Since a portion of this payment is applied to your principal, at the end of 5 years, your balloon payment due is $405,339.94 rather than $500,000.
If you have a 2-step balloon mortgage, you may have made interest-only payments for a time, then switched to larger payments that include both interest and principal. In this case, the ending balloon payment differs depending on how much you have paid toward the principal balance over the entire loan term.
You may also be able to make additional payments, further lowering your principal balance. However, checking with your lender to confirm there is no prepayment penalty is important.
Final Balloon Lump Sum Payment
At the end of the loan term, you are responsible for paying the lender’s remaining balance. You may do this by taking out a new loan and using the funds to pay off your current loan or by making a lump-sum cash payment.
Typically, the final payment is due on the loan maturity date. However, the exact date depends on the loan terms, which are established at the time you sign your initial loan documents.
Refinancing With a Balloon Loan
It’s common for borrowers to refinance their balloon mortgages by taking out a new loan to pay off the balance. When doing this, you may take out another loan with a five or seven year term or move to a traditional 15-year or 30-year mortgage.
Remember that you need to qualify for a new loan, so keeping your credit, income, and assets in good standing is essential.
There are typically no restrictions or penalties related to refinancing your balloon loan, even if you do it before the end of the loan term. However, since loan terms vary, it’s important to confirm this with your lender.
Who Are Balloon Notes For?
The average consumer typically does not need a balloon loan, and the risks can outweigh the potential benefits. However, there are some circumstances when a balloon mortgage could be advantageous.
For example, a home buyer may plan to purchase and then resell a home before the loan term is up, using the proceeds from the sale to pay off the final balloon payment. If you’re planning to hold a property for a short time or expecting a significant amount of income in the near future, a balloon loan may make sense.
You may also consider a balloon mortgage if you have the cash available to pay off the balance but wish to use the money elsewhere until the final payment is due. This could make the loan less risky since you already have the financial means to make the required balloon payment.
Business owners may also benefit from a balloon mortgage if they anticipate the property will generate enough sales and profits to repay the loan when the term ends.
Risks to Keep in Mind
While the thought of a balloon mortgage may seem appealing, there are some significant potential risks to consider. First, you must be able to pay or refinance your final balloon payment.
If you plan to sell the home, you could have difficulty finding a buyer or end up in financial trouble if the home’s value has decreased below what you owe. If you’re planning to refinance and your financial circumstances have changed, you could also find that you cannot qualify for a new loan. Since your home serves as collateral for your balloon mortgage, the lender could foreclose if you’re unable to make the final payment, and you could lose your home.
Also, keep in mind that refinancing a loan may require closing costs, and the new loan is based on the current market rates. This could make your new loan more costly than you expected.
Balloon Mortgage vs. Conventional Mortgage
A conventional mortgage is a popular alternative to balloon mortgages. While balloon mortgages typically have lower monthly payments, they are also categorized as non-qualified mortgages. This may make finding a lender and qualifying for the loan more difficult.
Since balloon mortgages are considered a higher-risk loan, the interest rate and down payment requirements may also be higher when compared to a conventional mortgage.
What Is a Non-qualified vs. Qualified Mortgage?
A qualified mortgage (QM) loan offers certain protections to lenders and borrowers and is considered one of the more stable loan types. They have established guidelines regarding a borrower’s debt-to-income ratio, allowable loan terms, and more. Interest-only payments and balloon payments are typically not allowed for qualified loans.
While conventional mortgages are qualified, a balloon mortgage is non-qualified. Non-qualified mortgages are typically offered by smaller private lenders that can set their own approval criteria.
There is typically a significant cost difference between conventional and balloon mortgages. When making a comparison, consider how the required down payment, interest rate, and principal payments impact the overall expense of your loan.
While the standard down payment for a conventional mortgage used to be 20%, today, your lender may allow you to put down anywhere from 3% to 15%, depending on the type of loan you chose and your financial circumstances. However, if you choose a balloon loan, the lender may have significantly higher down payment requirements.
Since balloon mortgages are considered riskier, they typically have higher interest rates when compared to conventional mortgages. In some cases, balloon rates on mortgage loans are much lower during the initial repayment period. However, they typically adjust to a higher rate and higher minimum payments once the initial payment period has passed.
Conventional mortgages are amortized to ensure the entire principal is paid off by the end of the loan term. A portion of each monthly loan payment goes toward interest; the remainder is applied to the mortgage principal.
Balloon mortgages are intended to leave a significant part of the principal unpaid at the end of the loan term. If you take out an interest-only balloon loan, your unpaid principal balance remains unchanged throughout the loan term.
Balloon mortgages have limited availability for multiple reasons. First, since they are non-qualified mortgages, many traditional lenders do not offer them. They’re typically issued by small, private lenders, so it can be a challenge to find a reputable lender that is willing to work with you.
Lenders typically set strict qualification criteria and require large down payments. If you don’t meet the financial requirements, you may have difficulty getting approved for a balloon loan. In contrast, conventional mortgages are widely available, and you may be able to qualify even if your credit score and debt-to-income ratios are less than ideal.
Pros and Cons of Balloon Payments for Your Mortgage
For certain home buyers, a balloon mortgage may have some clear advantages. However, they are not right for everyone. Before choosing a balloon note for your property purchase, consider these potential pros and cons.
Depending on your circumstances, a balloon mortgage can create unique opportunities. With the right plan in place, you may be able to capitalize on these benefits:
- Low monthly payments: Balloon loans typically have lower monthly payments when compared to other mortgage types, making your loan more affordable in the short term.
- Ability to purchase a higher-priced property: Lower monthly payments may provide access to a property you otherwise could not afford.
- Repayment flexibility: Instead of locking in a higher rate for a long period, balloon loans allow you to refinance at the end of the period, potentially to a lower rate.
- Ability to upgrade property before resale: Lower monthly payments could allow you to spend more on property upgrades, increasing property value before you sell.
While the advantages of a balloon mortgage may sound appealing, there are some potentially serious risks that you should not ignore. These include:
- Higher overall costs: Despite the lower initial payments, the overall cost of balloon loans may be higher, especially if there is an interest-only component.
- Refinancing challenges: You may find that you cannot secure financing when it’s time to pay off your balloon loan, which can put you in danger of default.
- Difficulty obtaining a balloon loan: Since they are typically issued by small, private lenders, you may have trouble finding a balloon loan or getting approved.
- The potential to lose your home: If you cannot make your balloon payment at the end of your loan term, the lender could foreclose, and you could lose your home.
How to Get a Balloon Mortgage
Obtaining a balloon mortgage is somewhat similar to taking out a conventional mortgage, with a few exceptions. If you’ve decided a balloon mortgage may be an option for you, the following steps can help you obtain financing.
1. Find and Compare Lender Terms
Since fewer lenders offer balloon loans, finding the right lender may require some legwork. If possible, try to find at least 2 to 3 potential lenders so you can compare each loan’s interest rates, down payment requirements, and loan terms. In some cases, you may need to go through a pre-qualification process to receive information regarding the specific loan terms available to you. Be sure to check into each lender’s reputation and reviews, as well.
2. Complete Your Application
Once you’ve selected a lender, it’s time to submit your mortgage application and provide the required documents. While this may vary among lenders, you’ll usually need to provide proof of income, a summary of your current assets and liabilities, credit information, and a copy of your driver’s license, Social Security card, and other identifying information.
3. Receive Your Loan
After you’ve submitted your application, it goes through an underwriting process. If approved, the next step is to close the loan. The timelines and details of this process vary depending on the lender you’re working with. When the loan is closed, the property purchase is complete. Then, you begin making your monthly payments to the lender.
Alternatives to Balloon Mortgages
If you’re still considering whether a balloon mortgage is right for you, exploring a few other options may be helpful. Each alternative below may involve less risk and cost less in the long run.
Private lenders offer conventional mortgage loans without government backing. Since they are not guaranteed by any type of government agency, they may have stricter requirements regarding the minimum required interest rate, debt-to-income (DTI) ratio, and down payment. These features make them inherently less risky.
A fixed-rate mortgage is a home loan with a specified interest rate that stays the same throughout the loan period, typically 15 to 30 years. The loan is amortized at the onset, and borrowers make fixed monthly payments through the end of the loan term. The loan is paid in full by the time the loan term ends.
This type of mortgage may be preferable to a balloon loan if you plan to stay in the home for an extended period. Many borrowers also appreciate the certainty of a fixed mortgage payment.
Adjustable-Rate Mortgage (ARM)
Adjustable-rate mortgages (ARMs) typically start with a low introductory rate and have an interest rate that adjusts at predetermined intervals, such as once a year. When the rate adjusts, it can go up or down depending on the current market conditions, and your monthly payment adjusts accordingly.
Like balloon loans, ARMs can be good for borrowers who plan to stay in the home for a shorter time. However, since they are designed to be paid off at the end of the loan term, you don’t have to worry about dealing with a balloon payment.
Fully Amortizing Mortgage
A fully amortizing mortgage has monthly loan payments calculated to ensure the loan is paid in full at the end of the loan’s set term. Each loan payment is divided between interest and principal, allowing you to continually reduce your principal balance as you get closer to the end of the loan term.
You may prefer this to a balloon loan to ensure your loan is paid in full and avoid a balloon payment. As long as you make your monthly mortgage payments, you also do not have to worry about losing your home to foreclosure.
Sometimes, you may wish to explore a government mortgage loan as an alternative. These loans are issued by private mortgage lenders and backed by the U.S. federal government. Since this backing helps protect the lender, these loans sometimes have more lenient qualification requirements. They are also amortized, so they are paid in full by the end of the loan term.
Federal Housing Administration (FHA) loans are designed to help low and middle income families purchase homes. While popular among first-time homebuyers, this is not a qualification requirement.
An FHA loan may be an excellent alternative to a balloon loan if you have a lower credit score or don’t have a large sum of money set aside for your down payment. FHA loans typically have a 15 or 30-year loan term, a fixed interest rate, and a set monthly payment.
Veteran’s Administration (VA) loans are exclusively for active-duty service members, veterans, and eligible surviving spouses. Unlike many other types of mortgage loans, VA loans don’t require a down payment or mortgage insurance. They also tend to have more lenient credit requirements.
If you qualify for a VA loan, this can be an affordable option compared to a balloon loan. You may be able to choose either a fixed-rate or an ARM for your VA loan, giving you additional flexibility and the potential to make smaller monthly payments early in the long term.
USDA loans are guaranteed by the Rural Development Single-Family Housing Guaranteed Loan Program, which is part of the U.S. Department of Agriculture. These loans offer no-down-payment mortgages to borrowers who purchase homes in eligible rural areas and towns. These loans may be granted directly through the USDA or issued by partner lenders.
If you’re considering buying a property in a qualifying area and you meet the income limits, this can be an affordable option compared to a balloon loan. Not only can you avoid the down payment altogether, but USDA loans also tend to have lower interest rates since the government is taking on the lending risk.
Putting It All Together
Deciding which type of mortgage loan is appropriate for your needs can be challenging. Balloon mortgages have some benefits for certain borrowers, but the potential risks outweigh the advantages for many.
While balloon mortgages may allow you to make smaller monthly payments for a set period, paying off the balance can present a challenge when the loan term ends. If you cannot refinance or pay the loan in cash, you could lose your home.
In many cases, considering other types of mortgage loans, such as conventional or government-backed mortgages, may be advantageous, as these are typically more affordable, easier to qualify for, and less risky. Before choosing any type of mortgage loan, it’s helpful to carefully weigh the potential pros and cons and discuss your options with a trusted financial professional.