Balloon mortgages are so named because the entire balance becomes due in full at a predetermined date. At that time, the payment on the note suddenly expands or balloons. This can be a disadvantage if you don't have the funds available, or can't refinance the mortgage. On the plus side, however, balloon loans offer lower monthly payments, which is their main appeal.
What children's birthday party is complete without balloons? When it's pulled out of a bag, a balloon is flat and deflated. But as you blow into it, it suddenly grows, little by little, until it's a full, round orb bringing smiles to the faces of kids of all ages.
A balloon mortgage works in a similar way. It's structured so that the borrower makes small monthly payments over a specified period of time. When that time period expires, the remaining balance of the loan is due. By that time, the amount owed is the size of an inflated balloon. This type of loan was intentionally created to help homeowners manage their finances.
Amortization is the industry term used to describe the calculation of monthly installments of principal and interest on a routine schedule. The longer the amortization schedule, the lower your payments will be. That's because the lender is giving you more time to pay back the money you borrowed.
For example, if you take out a conventional fixed-rate 30-year mortgage, your payments will be spread over three decades. On the other hand, if you have a 15-year mortgage, your monthly payments will be higher because you're scheduled to pay back the loan twice as quickly.
Best of both worlds
Balloon loans were created to help consumers manage their finances by allowing them to purchase more house with small monthly payments. With a balloon mortgage, your lender will calculate your monthly payment amortization schedule as if you were using a 30-year mortgage. As a result, your monthly payments will be much lower than they would be if you borrowed the same amount of cash for five or seven years, but didn't use a balloon loan.
The challenge, however, occurs when the loan expires. At that point, you'll need to come up with a huge sum of cash to pay off the balance. Many people either refinance their loans, or take out an entirely new mortgage to fulfill their obligation. If you choose a balloon loan, you'll need to plan ahead in order to have sufficient funds on hand to make the balloon payment on time. If you can't come up with the funds, you run the risk of losing your home.
When balloons are smart
A balloon mortgage might be a good choice if you plan to sell or refinance your home within five to seven years. In this scenario, you'll get lower payments, and then sell or refinance your loan to pay off the balloon portion of the mortgage. Many lenders have an automatic "reset" feature built into their balloon loans, so that the loan automatically converts to a new loan if the balloon payment comes due and you can't pay it.
Don't assume, however, that your loan has a refinance option; some lenders don't allow it. As with any type of loan, be sure to ask questions to fully understand the terms of your balloon mortgage before signing. When used responsibly, balloon loan can be as simple and joyful as child's play.