Balloon Mortgages Explained: What it is and How it Works
Balloon mortgages offer homebuyers a lower-than-normal monthly payment on their home loans. But in exchange, the borrower’s final payment of the loan term will be far larger than the typical payment amount. This large final payment is called a balloon mortgage payment.
The balloon mortgage payment must be at least twice as large as the normal monthly amount to qualify as a balloon payment. Depending on the lender, the loan type and the circumstances of the deal, the balloon payment can be as much as 50% of the loan.
Here is everything you need to know about balloon payments.
Balloon Payment Defined
A balloon payment is a one-time payment, made at the end of your loan term, that is larger than your normal payment amounts. Having a balloon payment reduces the amount you pay each month by saving a large amount of money for the final payment.
Balloon Payment Types
Balloon payments aren’t just for home loans. Many different loan types can include balloon payments. Here are three of the most common balloon payment types.
Balloon mortgages are the most common type of balloon loan. Homebuyers may choose a balloon mortgage to keep their monthly payments as low as possible. This is particularly the case for homebuyers who plan to sell or refinance their loan before the final payment is due.
In most cases, lenders expect balloon mortgages to be repaid fairly quickly. Rather than the industry-standard 15- or 30-year mortgage, balloon mortgage terms are usually only five to seven years.
Investors might choose a balloon loan for short-term real estate investments. For example, if an investor plans to purchase a fixer-upper and spend a few years renovating the property to resell, a 5-year balloon mortgage could make sense. The monthly payments would be lower than a standard home loan, allowing the investor to allocate more funding to the renovations, and the investor would sell the property to repay the remaining balance before the final payment comes due.
Adjustable-rate mortgages (ARMs) are sometimes mistaken for balloon mortgages, but they are different. With ARMs, your mortgage payments adjust based on interest rate fluctuations after a low introductory rate period. For example, you could have an introductory interest rate of 4% for the first five years of your loan. After that, your interest rate would change to reflect current market rates, causing monthly payments to either increase or decrease . Unlike balloon mortgages, ARMs do not have a predetermined increase. Instead, the rates are automatically adjusted at fixed intervals.
Balloon Auto Loans
Auto loans can also have a balloon loan structure. This is particularly useful to vehicle buyers who need transportation to and from work, but cannot afford monthly auto loan payments at standard monthly rates. A balloon auto loan would defer a portion of the principal balance to the end of the loan term to allow the buyer to purchase a vehicle with lower monthly payments. The buyer could then save money for the balloon payment throughout the term, refinance the loan before the balloon payment comes due, or sell the car to repay the remaining balance.
Balloon Business Loans
Established businesses with a solid financial history can use balloon business loans to finance a short-term need. For example, if equipment is needed for a new product line, the business might decide to fund the acquisition with a balloon business loan rather than tie up capital in new equipment. This would allow the company to begin production on the new product, which could raise the revenue to pay off the debt, while keeping their capital available for other investments.
Understanding Amortization on a Balloon Mortgage
Amortization is simply the schedule of paying off the balance of your loan. It applies to all loan types, but let’s look specifically at how amortization works with home mortgages.
Every month, a certain amount of your mortgage payment is used for paying down your loan's principal balance, while the rest is directed toward interest payments. As a note, you might also have property taxes and homeowner’s insurance included in your mortgage payment, but only the principal and interest payments affect amortization.
With fixed-rate mortgages, the percentage of the payment that goes toward your principal balance changes with each payment. Your early loan term payments mostly go toward interest, while only a small percentage goes toward paying down your principal loan balance. The closer you get to the end of the loan, the higher the portion of your payment goes toward the principal.
With traditional mortgages, the principal balance is fully amortized over the term of the loan. This means that your loan balance is $0 at the end of the loan term. But an amortization schedule with balloon payments is different because balloon mortgages do not fully amortize. At the end of the loan term, you still owe part of the principal. This remaining amount is paid through the large balloon payment.
How to Get Out of a Balloon Mortgage
If you are concerned that you might not have the money to cover the large final payment, there are a few different options for getting out of that balloon payment.
Refinancing is when you replace an existing loan with a new loan. The new loan pays off the old loan, allowing you to repay the new loan under different terms. You could decide to get a new non-balloon loan with a longer term so that your monthly payments stay manageable. Your refinance options depend on the terms that lenders are offering when you’re ready to refinance.
2. Sell the Asset
Whether your balloon loan was for a home, a vehicle or business equipment, you could sell the asset and use the proceeds to repay the loan.
3. Make a plan to pay it off
In our business loan example, we explained that companies could plan to repay the loan with revenue generated by equipment funded by the loan. If your home loan has a balloon payment, you could increase your payment amount each month to reduce the principal balance.
If you don’t have extra income to set aside, you might consider renting out space on your property (storage space, parking space or even a guest cottage), and saving that money for the balloon payment. It’s also important to check for prepayment penalties if you’re planning to repay your loan early.
4. Negotiate an extension
Some lenders might allow more time before your balloon payment comes due. But talk with your lender as soon as possible; there is no guarantee that they will be willing to do this.
Is a Balloon Payment a Good Idea?
Like most financing structures, balloon payments can work well in some situations, while not making much sense in others. The following pros and cons of balloon payments can help you decide if this option works with your unique circumstances.
Pros of Balloon Payments
Balloon payments can be a smart strategic option for borrowers who have a plan to cover the expense of the final payment. The benefits of balloon payments include:
Affordable monthly payments. By delaying a large portion of the balance until the end, monthly payments are lower than they would be under standard loan terms.
Shorter underwriting process. The process of qualifying for a balloon loan may require less documentation than applying and qualifying for a standard loan. This means less work for the loan underwriter, and could mean lower fees for originating the loan.
Exit options. As we’ve seen, there are multiple ways to get out of a balloon payment if needed.
Cons of Balloon Payments
There are also a few potential disadvantages of balloon payments to consider, including:
Large final payment. If you have a plan to cover the large final payment, this might not be an issue. But the risk of not being able to make the final payment is a potential disadvantage.
Slower equity accumulation. With lower monthly payments than a standard loan, you’re paying down the principal balance more slowly. This means you’re not building equity in your property as quickly as you might with a traditional home loan.
Higher foreclosure risk. If you cannot afford your balloon payment (or exit the loan in one of the other ways we discussed), the bank could potentially foreclose on the difference, causing you to lose your home or investment property. This is especially risky if real estate values decrease to the point where your home is worth less than the remaining balance of your loan. In that case, even selling the property wouldn’t help because you wouldn’t earn enough from the sale to repay the loan.
Possible difficulty finding a willing lender. Some lenders don’t offer balloon mortgages, while others won’t refinance balloon mortgages. It’s best to line up your lenders early in the process.
The Final Word on Balloon Mortgages
Balloon mortgages are not the best fit for everyone. Many homebuyers are better served by conventional mortgages or government-backed mortgages like VA loans. But when used strategically, balloon mortgages can be a useful tool. They keep your payments low and buy you time to either sell, refinance or collect the money necessary for that final payment. Be sure to consider your specific circumstances and requirements when determining if a balloon mortgage is right for you.