A balloon mortgage might be appealing when it offers a lower mortgage rate — and therefore a lower monthly payment — than a conventional fixed-rate loan.
Since many homeowners don’t plan to stay in their homes long-term, a loan with short-term savings can be enticing. Still, accepting responsibility for a large balloon payment is a major risk.
What is a balloon mortgage?
A balloon mortgage is a home loan that requires fixed monthly payments for the first several years. After that, you’ll have to pay the remaining principal balance at once.
Here’s how that happens. With a balloon mortgage, the term is far shorter than the amortization period:
- Term: The number of years the borrower has to repay the loan.
- Amortization period: The number of years over which the loan’s payment is calculated.
For example, the popular 30-year fixed-rate mortgage has a 30-year term and a 30-year amortization period. You make the same payment every month for 30 years (360 months), and then you’ve completely paid off your loan.
A balloon mortgage, by comparison, might have a five-year term and a 30-year amortization. You’ll make the same payment every month for five years (60 months) that you would have made on the loan with the 30-year term. But after that, you’ll owe all of the remaining principal.
Keep in mind: The term for a balloon mortgage doesn’t have to be five years. It could be seven years, 10 years, 15 years, or whatever the lender is willing to offer.
How do balloon mortgages work?
Balloon mortgages allow you to make lower monthly payments than what would normally be allowed with other types of mortgages. In exchange, you have to repay the full amount borrowed sooner than you would with, say, a conventional mortgage.
The most common type of mortgage — a 30-year fixed-rate home loan — gives you three decades to repay the principal. By comparison, a balloon mortgage might require you to pay off the principal after five years. During the five years that you carry the mortgage, you might pay only interest, or interest plus a small amount of principal — it just depends on the type of balloon mortgage you take out.
Tip: Many people repay the balance by selling or refinancing their home. Ultimately, you’ll need to find a way to make the large balloon payment so you don’t default on the loan, ruin your credit score, and potentially lose your real estate.
Balloon payment schedule
Lenders offer different ways to structure a balloon mortgage and different term lengths. One possibility might require you to pay both interest and principal each month for five years, followed by a large balloon payment at the end of the term.
The chart below (an amortization schedule) shows what these payments would look like on a $300,000 loan with an interest rate of 1.8% structured as a 30/5 balloon mortgage.
A 30/5 structure means the lender calculates your monthly payments as if you’ll be repaying the loan for 30 years, but you actually only make those payments for five years. At the end of the five-year (60-month) term, you’ll repay the remaining principal, or $260,534.53, as a lump sum.
How balloon mortgages compare to other home loans
Here’s what your payments would look like through the first five years on a $300,000 home loan structured in different ways.
Pros
- You’ll enjoy a lower interest rate. A lower interest rate can save you money in the short run. Using the numbers from the loan comparison table in the previous section, you’d pay $64,746 over the first five years of the balloon loan, $73,483 over the first five years of the ARM, and $75,889 over the first five years of the 30-year fixed-rate conventional loan.
- The monthly payments are smaller. You can more easily fit a smaller monthly payment into a tight budget. Smaller monthly payments can also help with cash flow in lean months if you’re a business owner whose monthly income fluctuates.
- It’s an alternative to conventional financing. A balloon mortgage may be an option for certain borrowers who don’t qualify for conventional financing. This doesn’t mean a balloon mortgage is a good idea if your finances are unstable. It means it might be an option if your financial profile doesn’t fit the types of borrowers that mainstream mortgages are designed for.
Cons
- Refinancing might not be possible. Your income could be lower or your property’s value might have sunk by the time you want to refinance. Interest rates could also be a lot higher than they are now, making your new payment unaffordable. Even if you can refinance, you’ll have to pay closing costs, which might negate your interest rate savings.
- Selling might be difficult. Demand for homes in your area might not be there. A natural disaster, zoning change, or loss of a major employer could make your property less desirable. You might not be able to sell for enough money to pay off your loan, let alone get your equity out.
- You could lose your home. If you can’t make the balloon payment, you can’t refinance, and you can’t sell, there’s a good chance your loan will go into foreclosure. It’s possible the lender could agree to a loan modification, but don’t count on it.
How to get out of a balloon mortgage
A balloon mortgage requires you to make a lump sum payment of principal at the end of your loan term. If you don’t want to come up with that kind of cash — or you have it but don’t want to spend it — here are three options.
Sell your home
If your local real estate market is strong enough, you may be able to sell your home before the final payment is due and use the proceeds to pay off the loan.
You’ll need to net enough from the sale after real estate commissions and other selling costs to cover the balance you owe.
Keep in mind: For home purchases involving a mortgage, closing can take up to two months. Make sure you give yourself enough time to list your home and find a buyer to meet your balloon payment deadline.
Refinance your home
If your income and credit are strong enough, and current interest rates are affordable, you may be able to refinance your balloon loan.
As with any mortgage refinance, your loan-to-value (LTV) ratio will be important. You’ll typically need an LTV of 80% or lower to refinance your home. For example, if you owe $250,000 on your mortgage, your home will need to be worth at least $312,500 to qualify with many lenders.
Pay down the principal faster
If you’re not interested in selling or refinancing the property but want to keep it, the only way to get out of your balloon loan will be to pay it off. This might mean paying several thousand dollars a month throughout your loan term — far more than the minimum.
Other possibilities include coming up with the lump sum from a savings or brokerage account, a retirement account, or by selling another asset. Consult a financial advisor before choosing one of these options because of their potential long-term consequences.
Alternatives to a balloon mortgage
If you’re tempted by a balloon mortgage but put off by the disadvantages, consider these alternatives.
Adjustable-rate mortgage (ARM)
- Best for: Low interest rates with no balloon payment
Adjustable-rate mortgages often have lower rates than 30-year fixed-rate mortgages. On top of that, an ARM with a 30-year term can have the lowest monthly payments available outside of a balloon mortgage.
However, the interest rate does reset after the initial fixed period, so these loans still carry some risk. For instance, you might have a low rate for five years, then see annual rate adjustments for the next 25 years.
These annual adjustments are far less risky than owing a balloon payment, though, especially since there are limits on how high an ARM’s rate can adjust.
Learn More: ARM vs. Fixed Mortgage: How to Choose Between Them
30-year fixed mortgage
- Best for: Stability with low monthly payments
A 30-year fixed-rate mortgage may not be much more expensive than an ARM. For a slightly higher interest rate, you get the security of knowing that your monthly mortgage payment will be exactly the same for the next 30 years.
The stability of the repayment schedule is one reason why both 30-year fixed and 15-year fixed mortgages are so popular.
Bank statement mortgage
- Best for: Certain self-employed borrowers
Contrary to what you might have heard, self-employed borrowers can qualify for conventional loans. But sometimes, taking all those business deductions means your income looks too low to repay a mortgage even though you have plenty of income.
That’s where a bank statement mortgage (also known as “no-doc loans”) can be helpful because it places more emphasis on your liquid assets. If you don’t really need the lowest monthly payment possible but are seeking a balloon loan because you don’t know how else to qualify, check into this option.
Shopping around for a mortgage can be stressful. Fortunately, Credible streamlines this process and makes comparing multiple lenders easy.
