When it comes to shopping for a mortgage, home buyers are all about finding the lowest interest rate for their home loan. It’s no wonder, then, that the relatively low interest rate of a balloon mortgage might entice thrifty shoppers.
Unfortunately, balloon mortgages are very risky for most borrowers and might not be worth the gamble. Before you consider this type of loan, make sure you do your homework.
Here’s what you need to know.
What Is A Balloon Mortgage?
Simply put, a balloon mortgage is a fixed-rate home loan with a relatively short term (usually 5, 7 or 10 years), after which the borrower must make a lump sum payment—or “balloon payment”—of the remaining balance.
Balloon mortgages differ from traditional mortgages in that the monthly payment consists mainly, or even entirely, of interest. Because balloon mortgages often come with lower monthly payments, they might appeal to buyers who plan to sell their home or refinance before the loan term ends—in other words, before the balloon payment comes due.
How Does A Balloon Mortgage Work?
Like most home loans, balloon mortgages provide buyers with the luxury of owning and living in a home they can’t afford to buy outright.
But unlike other home loans, a balloon mortgage doesn’t fully amortize over the life of the loan. What does that mean? With a traditional mortgage, the borrower makes monthly payments consisting of principal and interest over a fixed period of time (usually 15 or 30 years), after which the loan is completely paid off. This process of paying down the balance, with interest, over a set period of time is called amortization. Instead of amortizing, however, the balance of a balloon mortgage may stay the same until the end of the term, when the borrower must pay the remaining loan balance.
Pros And Cons Of A Balloon Mortgage
Like all mortgage options, a balloon mortgage comes with both pros and cons. Below, you’ll find some of the main advantages and disadvantages to keep in mind when considering this type of home loan.
Here are the primary benefits to a balloon mortgage.
- Lower interest rate: There’s no doubting the appeal of a lower interest rate and APR when financing a home. Yes, you’re more likely to get a lower interest rate – and, as a result, a lower monthly payment – with a balloon mortgage than with many traditional mortgages. However, this isn’t always the case. Make sure you weigh your options carefully.
- Shorter loan term: Typically speaking, a balloon mortgage will come with a shorter loan term than a traditional mortgage. This is a bit of a double-edged sword: A shorter loan term means a lot less interest paid over the life of the loan (which reduces overall cost), but it also means a quick turnaround before borrowers owe the remaining loan balance all at once.
- Ability to buy more house: Lower monthly payments, coupled with the potential to qualify for higher loan amounts, means borrowers can afford to buy more house, and buy sooner than they would otherwise. A word to the wise, though: Qualifying for a bigger loan doesn’t mean it’s a good idea to buy the most expensive home possible.
Before you get too excited about the advantages of a balloon mortgage, let’s have a look at the major drawbacks:
- Lack of equity: Because monthly payments against a balloon mortgage consist entirely (or mostly) of interest, borrowers accrue little to no equity in their home before making the balloon payment. This puts homeowners in a precarious position because, for a stretch of time, they may pay a substantial amount of money toward a home without coming any closer to owning it outright.
- Vulnerability to market changes: Let’s say you take out a balloon mortgage with the expectation that you will sell the home before you have to pay your lump sum. If the real estate market worsens during the life of the loan, you may have difficulty selling the home, meaning you could face the balloon payment.
- Difficulty refinancing: Let’s say you planned to refinance your balloon mortgage before the end of the term. Because refinancing typically requires borrowers to have sufficient equity in their home, you might have trouble refinancing your loan. This, too, could mean you’re on the hook for the balloon payment.
Should You Get A Balloon Mortgage?
The short answer is: probably not.
Unless you’re expecting, with utter certainty, to receive a massive inheritance, work bonus, or other windfall equal to (or greater than) the amount of the lump sum payment, you should probably think twice before taking out a balloon mortgage.
What about refinancing or selling the home? Because the housing market is subject to unforeseeable factors, it’s simply too risky to count on the likelihood of being able to refinance or sell before the end of the term.
Balloon mortgages may also be difficult to find, in part because they’re risky ventures for lenders, too.
Balloon Mortgage Alternatives
Finding the right alternative to a balloon mortgage will depend on an individual’s borrowing and buying needs.
That said, if you’re looking for a short, fixed period of monthly payments at a relatively lower interest rate, you might consider an adjustable rate mortgage (ARM). Or, if you value long-term consistency and stability, you might look into a 30-year fixed-rate mortgage, which has long been the industry standard for its affordability, partly because it allows for lower monthly payments over an extended period of time.
Not sure which type of mortgage is right for you? Contact a home loan expert to get the advice you need.