What Is a Balloon Mortgage?

What Is a Balloon Mortgage?

A balloon mortgage is a home loan that begins with low monthly payments and ends with a one-time "balloon" payment that typically covers the remaining loan balance. Balloon mortgages are much less common than conventional 30-year fixed-rate or traditional adjustable-rate mortgages. Moreover, though a balloon mortgage can help lower your monthly payments, you'll need a plan for making that last lump-sum payment. If you don't have the cash to cover it, you may need to refinance or sell your home to avoid foreclosure.

How Does a Balloon Mortgage Work?

A typical balloon mortgage offers low monthly payments over five or 10 years, but requires a large final payment—the "balloon"—to pay off the loan. Balloon mortgages generally aren't a good option for homebuyers who intend to stay in their homes long term or who want a fixed house payment. Short-term homebuyers or people who expect a significant boost to their finances may find balloon loans a useful option.

Here's how a balloon mortgage works.

Example of a Balloon Mortgage

Let's say you want to purchase a home for $400,000 with an $80,000 down payment. You find a five-year balloon mortgage with a low interest rate of 6.49%. Here's how your loan's financials might look:

• Starting monthly payment: $2,021
• Total monthly payments (over five years): $121,231
• Total interest paid: $97,835
• Ending balloon payment: $299,521

A starting monthly payment of $2,021 is about $108 cheaper than the $2,129 monthly payment you might have with a 30-year conventional mortgage at 7%.

The sticking point is the balloon payment. In our example, your mortgage effectively ends in five years. At that point, you need to come up with roughly $300,000 in cash, refinance or sell your home to raise the money.

Tip: Interest rates on balloon mortgages aren't always lower. In fact, they may have higher rates to compensate for what lenders perceive to be higher risks. Before taking out any mortgage, use a mortgage calculator to compare payments using different interest rates and loan terms so you fully understand what your alternatives are.

How Do You Pay Off a Balloon Mortgage?

You can pay off a balloon mortgage in a lump sum or by refinancing or selling your home. Here's what each entails:

• Pay cash. The simplest way to pay off a balloon mortgage is to make the final lump-sum payment. Of course, this means having a clear plan to save these funds or raise money some other way by the balloon payment deadline.
• Refinance. Before your balloon payment is due, you can refinance your loan balance and start fresh. The downsides: You'll need to pay closing costs again and will have to go with the prevailing interest rate, which may be higher. Also, it may take longer to pay off your loan if you refinance to a 30-year loan after carrying a balloon mortgage for five or 10 years.
• Sell. If paying cash and refinancing aren't options, you can sell your home and use the proceeds to make your balloon payment.

In some cases, you may be able to negotiate a short-term extension on your balloon payment, or you may have the option to reset your loan at the end of its term. A reset recalculates your loan balance at a current interest rate and full amortization over the (new) remaining loan period. This spares you the need to come up with cash, but will likely result in a higher monthly payment.

Pros and Cons of a Balloon Mortgage

Balloon mortgages may offer some advantages, but it's important to consider the numerous disadvantages before settling on this type of home loan.

Should You Get a Balloon Mortgage?

Weigh your options carefully if you're considering a balloon mortgage. For most homeowners, a balloon mortgage carries more risk than reward. Unless you have an iron-clad plan that allows you to confidently pay up, refinance or sell your home before the balloon payment is due, another type of mortgage might give you more flexibility (and less angst).

How to Get a Balloon Mortgage

Finding a balloon mortgage isn't easy. Balloon payments make these loans non-qualified mortgages: They don't follow consumer protections put in place by the Dodd-Frank Act and the Consumer Financial Protection Bureau (CFPB) to help ensure borrowers can afford to repay their loans. For that reason, many large lenders don't offer balloon mortgages. To find one, you may need to seek out smaller lenders that offer non-qualified loans.

A non-qualified mortgage may be helpful to you if you have income that's difficult to document, carry a lot of debt or have had recent negative credit issues. However, you should still expect to demonstrate a strong credit history and the ability to repay your loan to qualify for a balloon mortgage.

Learn more: The Complete Guide on How to Get a Mortgage

Alternatives to a Balloon Mortgage

Before choosing a balloon mortgage, consider alternatives such as adjustable-rate loans, interest-only loans and even 30-year fixed-rate mortgages. You may be able to find an affordable payment option that doesn't have a five- or 10-year expiration date. Here are a few alternatives to consider.

Adjustable-Rate Mortgages

An adjustable-rate mortgage (ARM) offers low fixed payments for an initial period, then adjusts periodically after that. For example, a 5/6 ARM has a fixed rate for five years, then adjusts every six months based on a financial index like the prime rate. Starting rates on an ARM are usually lower than they are for a conventional loan, so you may get lower monthly payments to start and no balloon payment at the end of the introductory period.

Interest-Only Loans

An interest-only mortgage has an initial period with relatively low interest-only payments and a second period with higher payments that consist of principal and interest. Although payments will definitely increase after the initial period (typically five to seven years), they generally don't require a balloon payment.

Construction-to-Permanent Loans

If you're considering a balloon mortgage to finance new construction, you may want to investigate a construction-to-permanent loan to see if it's a better fit. This type of loan begins with interest-only payments, then converts to a normal mortgage loan when building is complete.

Fixed-Rate Mortgages

Fixed-rate mortgages have the same interest rate and monthly payment from start to finish. Although the interest rate and payment may be somewhat higher for a fixed-rate versus a balloon mortgage, a fixed-rate loan has no surprises; that means no introductory periods, no rate adjustments and no balloon payments. These loans are also widely available, so it's easy to comparison shop.

Learn more: How to Compare Mortgage Offers

The Bottom Line

If you're considering a balloon mortgage (or any other home loan), it's worth your while to investigate as many alternatives as possible. Spend some time shopping for a mortgage. Check your FICO^® Score^☉ for free from Experian and try using an online marketplace to find multiple loans that fit your credit profile and needs. Getting a mortgage is a huge financial step. Getting the right one should help you feel at home.