What is a Balloon Mortgage?
The mere mention of the words “balloon mortgage” is enough to make some people’s hair stand on edge. They have likely been burned by one in the past, or at least know someone who has. To most people, balloon mortgages are a dangerous risk to avoid.
I don’t know how their reputation was soured, but I suspect it was from an overreaction of a few good people who were hurt by them.
Is there any risk involved in a balloon mortgage? Of course there is. But any mortgage has a degree of risk to it if you can’t afford to make the payments. I will balloon mortgages are typically more risky than a standard mortgage, but it also has its advantages.
So how exactly does a balloon mortgage work? Let’s compare it to a standard mortgage so we can see the differences.
With a standard, fixed rate mortgage, you pay a specified amount each month for a fixed term (usually 30 years). The interest rate stays the same throughout the loan, though some loans have rates that adjust periodically.
Either way you’re looking at about thirty years of pretty steady payments.
But with a balloon mortgage the term is much shorter. You only have to pay a lesser amount for a shorter period of time. The term of most balloon mortgages is about five to seven years, though it can be as low as three or as high as ten.
You do not pay the entire balance of the loan over the specified term. Instead, there is a large balance left that must be paid. This is called the balloon payment.
Why would anyone want to face such a sudden and massive payment? If they plan to live in the home only a short time they will have already moved before the balloon payment comes due. Or if they expect a large increase in income they may be able to pay off the balance due.
The danger here is that circumstances can change. If you are unable to move or make the final payment you could lose the house.
This can be avoided by including a clause in the balloon mortgage that allows you to convert it to a standard mortgage. Think of it like leasing a car and then buying it. You make regular payments for a few years and then you have to choose whether to pay the balance in full or refinance it into a standard car payment.
Be aware though that if interest rates have risen you could find your payments are suddenly a lot higher.
Overall, balloon mortgages are not the best option for most people. But they can be very useful in the right circumstances. Just be sure you aware of all the risks before signing on the dotted line.
Article Courtesy of Home Loan Application Center