What is a Balloon Mortgage?
From ARMs to FHA to VA loans and everything in between, when it comes to choosing a home mortgage program, there is practically one to match every hopeful buyer’s specifications. One very unique type is known as a “balloon mortgage.” Just like its namesake, this program’s final payment scheme inflates or “blows up” to a substantially larger than normal amount that becomes due all at once in order to pay off the remaining balance.
Borrowers choose this type of loan because balloon mortgages come with lower interest rates for a specific amount of time. For that reason, they are often confused with an ARM or adjustable rate mortgage. A balloon mortgage also comes with an interest rate that is fixed for a certain period of time. That lower fixed rate phase is usually between three to ten years. After that, the rate can change. During the fixed rate period, the borrower is able to enjoy the same peace of mind that traditional fixed rate mortgage holders do. They know what to expect since their home loan payment is the same amount each month – at least during the initial phase.
Balloon mortgages are decidedly different from fixed-rate and adjustable rate mortgages because they require a lump sum payout at the end of the initial or amortized payment period. Although this is very unappealing to the vast majority of prospective borrowers out there, it is often viewed as a good option among real estate investors.
Here’s how it works for investors: During the fixed interest time frame they can take advantage of any other investment opportunities. The more manageable fixed rate loan frees up their capital and allows it to build up. If all goes well, the lump sum is paid off when it comes due and the investor can enjoy positive cash flow since they have paid off the outstanding mortgage.
If the holder of a balloon mortgage is just a traditional homeowner, he or she can convert it to another form through refinancing before the fixed period ends. They can also choose to sell the home and (hopefully) make enough of a profit from the sale to pay off the lump sum balance.
The Benefits of a Balloon Mortgage
Balloon mortgages can be very beneficial when everything goes according to plan. For instance, if the owner is not choosing to live in the house for an extended period of time, a balloon mortgage will allow the individual to pay a fixed amount at a low rate of interest for the time that he or she plans to live there. In the best-case scenario, when the owner sells the property, the lump sum amount can be paid off and hopefully, there will be money left over. The situation can get even better when the borrower makes improvements to the property and it appreciates over time. This is the way savvy investors do it, knowing that their efforts will be rewarded and fetch a higher selling price.
Drawbacks and Risks
On the flip side, the borrower’s situation that existed when the balloon mortgage was initiated can change for the worse. For example, the homeowner may lose his or her job, have health issues or other serious and expensive setbacks.
Although there is always the option of refinancing a balloon mortgage, such a change comes with additional expenses including closing costs and the likelihood of a higher interest rate.
Opting for a balloon mortgage can be a profitable idea for those climbing the corporate ladder and have the realistic prospect of future pay raises. Those expecting a cash windfall, such as an inheritance, over the next few years, may be good balloon mortgage candidates. This type of mortgage can also be an effective strategy for individuals who relocate often and do not intend to stay in their newly acquired homes for the long term.
Another plus to consider is that some lenders may feel a balloon mortgage comes with a lower risk. That is due to the fact that these types of loans mature within five to seven years. Even though some lenders may view these as more manageable than a 3 or 5 year ARM, there is always a chance of foreclosure in and the risk of losing your home could be higher with a balloon mortgage.
In addition the large lump sum amount needed to pay on the day the loan reaches maturity, failing to do so prevents approval for loan refinancing. It also can increase the risk of foreclosure and make things more difficult. This type of situation happened frequently during the 2008 mortgage crisis. Thousands of people with balloon mortgages faced foreclosure because they could not sell their homes on time and pay off their loan balances. Then, since they were behind, getting approval for refinancing was extremely difficult if not impossible.
It pays to consult a professional mortgage lender or financial planner when weighing options for financing a home. Since such a purchase is likely the largest you’ll ever make, it’s one you’ll want to feel one hundred percent secure about!