What is a balloon mortgage?

How does a balloon mortgage work?

With a balloon mortgage, you generally make payments during the course of the loan term, but these payments only cover interest and maybe a portion of your principal balance. At some point, you are also expected to make a large lump-sum payment (called a balloon payment). This is often required at the end of a loan term to pay off the remaining balance.

Some balloon mortgages don’t even require you to make monthly payments.

Balloon mortgages are generally short-term loans with lengths between five and seven years. They may also have fixed or variable interest rates.

These mortgages aren’t as widely available today as they were before the Great Recession because they can be risky for both the borrower and the lender.

There are also new regulations that exclude balloon payments from qualified mortgages, a category of mortgages where it's assumed the lender made a good-faith effort to assess whether the borrower has the ability to repay the loan.

In most cases, when the balloon payment comes due, borrowers either pay off the balance with their savings, refinance into a traditional loan or sell the home.

Balloon mortgage rates

Interest rates for balloon mortgages can be fixed or variable, but they are otherwise hard to generalize. Some are lower than rates for traditional mortgages, but others are higher because of the added risk to the lender. Your rate will vary based on your lender, the specifics of your loan and your financial situation.

Types of balloon mortgage

While all balloon mortgages are similar, there are some variations. There are three main types of balloon mortgages, and the type you choose affects how large your monthly mortgage payment is.

Interest and principal payments

Your payments may be put towards a combination of interest and principal if you decide to obtain a balloon mortgage. Say you take out a $250,000 loan at 3% for seven years. Your loan may still be amortized like a 30-year loan, but the remaining balance is due at the end of seven years. With a traditional loan, the sum of all of your payments over 30 years would pay off your entire balance.

In this scenario, your monthly payment would be $1,054.01, which includes principal plus interest. On a standard amortization schedule, each payment will have you paying off slightly more principal as you approach the end of the term.

For example, with your first monthly payment, $429.01 is put toward principal, and $625 is put toward interest. The final monthly payment at the end of seven years would include $526.49 for principal and $527.52 for interest. The lump sum due at the end is $211,009.36.

Interest-only payments

With an interest-only mortgage, your monthly payments won’t be allocated to the principal — instead, they’ll just cover the monthly interest. At the end of the loan term, the entire principal will be due in one lump-sum payment.

In the scenario above, your monthly payment would be $625 and remain fixed during the loan term. At the end of your loan term, you would owe $250,000.

No monthly payments

This type of mortgage doesn’t require you to make any monthly payments. However, they usually come with much shorter terms (like one year), and the lump-sum payment at the end of the term is a combination of interest and principal. These mortgages could be a good fit for someone who flips homes for profit.

Balloon mortgage pros and cons

Balloon mortgages give you additional flexibility, but the large payment due at the end of your loan term may be too much for many people to easily handle. Before taking out a balloon mortgage, it's essential to consider the advantages and drawbacks to avoid putting yourself in a bad financial situation.

Pros

• Lower monthly payments: Your monthly payment is likely to be lower with a balloon mortgage than with a traditional mortgage, especially if you make interest-only payments. You may not even need to make monthly payments with a balloon mortgage.
• Borrowers with unsteady income can qualify: Some individuals (like investment bankers) earn bonuses that are a large part of their annual pay. While this unsteady income can sometimes keep you from qualifying for a traditional (conforming) mortgage, you may be in luck with a balloon mortgage. However, you’ll still need to provide proof of income as part of the application process.
• Seller financing available: In some cases, it’s possible for a home seller to provide a loan to a buyer so that the buyer can purchase their home. The buyer then makes the down payment and monthly payments to the seller. Sellers may not want the risks of long-term financing, so they often offer a balloon mortgage with a lump sum due after five years. Seller financing comes with its own set of advantages, like reduced closing costs and shorter due diligence periods.
• Flexibility in saving and investing: Lower monthly payments mean you have the flexibility to decide how to save for the lump-sum payment. It’s possible to make investment choices that earn enough over the years to help you pay off the remaining balance when it’s due.

Cons

• Large lump-sum payment required: If you’re borrowing a balloon mortgage, you’ll want a plan for making the balloon payment once it’s due. It’s possible to pay it off from your savings if you’re diligent, but many borrowers either sell their homes or refinance to avoid making this large payment.
• Builds little or no equity: Equity is the amount of money you have in your home, usually calculated as your home’s current value minus your mortgage debt. Because monthly payments on a balloon mortgage don’t contribute much, if anything, toward paying off your mortgage principal, you’re not going to build much equity until you make your lump-sum payment.
• High risk of foreclosure: Balloon mortgages carry a high risk of foreclosure because borrowers may be unable to make the balloon payment when it comes due. Foreclosure can force you from your home, and it carries some serious consequences to your credit, leaving a red flag on your credit report for seven years.
• Refinancing could be difficult: Because you may have little equity in the property by the end of your monthly payments, lenders may be hesitant to help you refinance. It’s possible that you’ll have to offer a substantial down payment in order to qualify for refinancing (on top of paying for closing costs). Mortgage interest rates also fluctuate with the market — by the time you want to refinance, rates could be higher than when you got your existing mortgage.

Paying off a balloon mortgage

You can make the lump-sum payment of a balloon mortgage in a number of ways. You could start by paying extra each month to your lender, which would reduce your final balance and build equity, or you could use savings or investment funds to pay off the remaining balance with cash.

If you don’t plan to use savings, you could also sell the home and use the proceeds from the sale to make the balloon payment. You’ll need to ensure that your home’s sale price is more than your remaining balance due so you can afford any real estate agent commissions and other fees associated with selling. This could be an issue if you live in an area where home values have dropped since you first obtained the balloon mortgage.

If you decide to stay in your home long-term, you may consider refinancing into a traditional loan. You would need to meet eligibility standards set by the lender, like down payment and credit score minimums.

Bottom line: Should you get a balloon mortgage?

A balloon mortgage can make sense in some scenarios — for example, if you’re confident you’ll live in your house for just a few years and you want affordable monthly payments. You might also explore a balloon mortgage if you get significant commissions and bonuses in addition to your base salary. In this instance, you could make interest-only payments each month and save for the balloon payment with your bonuses.

Those who flip houses may also find balloon mortgages beneficial. Usually, these real estate investors plan to renovate and resell the property before the balloon payment is due, and the monthly payments are often lower than what traditional loans offer.

In short, balloon mortgages carry a great deal of risk and can be hard to find. They make sense for some buyers, but typical buyers will often do better with another loan type.