Balloon Mortgage

Balloon Mortgage – Definition

A balloon mortgage is a loan type where the borrower makes a fixed monthly payment for a fixed amount of time ranging from 5 to 15 years, and then is required to payoff outstanding principal balance on the home with a lump sum payment.  A balloon mortage uses a 30 year amortization table; however, the interest rate will be lower with the balloon simply due to the fact that the lender is assuming less interest rate risk with a loan that spans 30 years.

Homeowners sometimes opt for this type of loan in anticipation of a large settlement or inheritance; however, those that do not can sometimes can enter into a risky situation.  If the loan does not get paid down, it will be refinanced with a new product and terms; however, a problem may arise in the future if the borrowers credit quality has dropped significantly or if home prices take a dive.  In the latter case, the borrower may be attempting to refinance the home with a LTV ratio of over 100%.  Rates may be extremely unfavorable in this situation and payments could drastically jump.

Balloon Mortgage Vs. ARM

A balloon mortgage is similar in theory to an adjustable rate mortgage; they both have a fixed rate period followed by an adjustment.  Assuming that the borrower refinances their mortgage, the balloon and ARM carry similar interest rate risks after the initial period.  While a balloon payment may be lower than a comparable termed ARM, the interest rate risk is large if interest rates rise dramatically.  ARMs have built in caps, or ceilings that limit how high interest rates move regardless of how high they actually are.  Conversely, balloon mortages will make the borrower refinance at the prevailing market rate, regardless of what it is.  When refinancing in a high rate enviroment, borrowers may no longer qualify for a loan if the payment jumps dramatically.  Additionally, there are costs associated with refinancing a home, the ARM will not incur this cost while the Balloon will.

In conclusion, be very careful and understand the risky nature of entering into a balloon mortgage.  In most cases, it is not advantageous for the borrower to do so primarily due to the risk that is associated to it once the borrower will need to refinance.  If you do not have the cash and you are not able to refinance, you will be forced to sell the house or foreclose on it.


Tim Ord
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