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What Is A Balloon Payment? Balloon Loans Explained

Written by Paul Esajian

If you’re in the market for a new mortgage, many financing options are available. One option you may have heard of is a balloon mortgage. This type of mortgage works differently from a traditional mortgage because you don’t pay it off entirely in installments. Instead, you make regular payments for a certain period, after which you pay off the balance of the mortgage in one lump sum.

This final lump sum payment is known as a “balloon payment.”

So, how does a balloon mortgage work, and why would you want to sign for one instead of a traditional mortgage? Here, we’ll explain the ins and outs of this unusual type of mortgage and the potential benefits and drawbacks. By the time you’re done reading, you’ll be a balloon mortgage expert. Let’s begin!

What Is A Balloon Payment?

With a traditional mortgage, a borrower takes out a loan with a long-term repayment schedule. The most common repayment term is 30 years, although there are shorter-term mortgages. The borrower makes regular monthly payments over the life of the loan. When they make their final payment, the loan has been fully paid off, and they hold title to the house.

In a balloon mortgage, the loan term is much shorter – typically only five to seven years. The buyer makes regular monthly payments during this period, just as they would with a traditional mortgage. But at the end of the loan term, the mortgage hasn’t fully amortized. In other words, the balance hasn’t been fully paid off.

When a balloon mortgage comes to an end, the borrower makes a final balloon payment to pay off the remaining loan balance. This payment is often several times the size of an ordinary payment, and can run into tens of thousands of dollars for a residential home. For commercial properties, it can be even higher.

Needless to say, this presents some hazards to the borrower. If you’re thinking about taking this kind of mortgage, make sure you know how you’re going to afford the final payment in advance.

Make sure to leave some room for error when making your plans. For example, if you’re planning to refinance at the end of the term, account for the fact that the property value might fall. In that case, you might find yourself unable to refinance without putting down additional money as a down payment.

Along the same lines, your financial situation might suddenly take a turn for the worst. If that happens, how are you going to make your balloon payment? These are things to think about before you sign on the line.


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balloon mortgage

How Does A Balloon Payment Work?

As you might imagine, balloon payments are more common for commercial mortgages than residential mortgages. Large companies can obtain financing, renovate a property, and sell it for a profit before the balloon payment is due. They can also opt to refinance later or pay the balloon payment outright.

The average homeowner typically won’t be able to afford a balloon payment. However, there are still some times a balloon mortgage can make sense. One is if you plan on refinancing before the balloon payment is due. You can take out a five- or a seven-year balloon mortgage, then refinance at a lower rate after four or six years.

Another situation is where you expect to move before the loan is due. This can make sense when your job involves working on a lot of short-term contracts.

For homeowners who want to refinance, balloon mortgages are sometimes offered as two-step mortgages via the same lender. The borrower takes a balloon mortgage for a certain number of years, but instead of a balloon payment, the loan will be converted into a traditional loan at the current market rate.

Both parties to a two-step mortgage are making a bet. The borrower is betting that interest rates will go down, while the bank is betting that they’ll go up.

Keep in mind that the reset itself is not a foregone conclusion. The borrower needs to make their payments consistently, and they need to maintain a steady income. If the reset is not approved for some reason, the balloon payment will be due instead.

Balloon Payment Qualifications

The federal Truth in Lending Act lays out the requirements that banks must follow before issuing any loans. Regulation Z requires banks to ensure that a borrower can repay any loans. So, you might think that a bank would have to consider your ability to make the balloon payment.

Unfortunately, that’s not always the case. Some exceptions allow a lender to only consider your ability to make the regular monthly payments. If you’re not doing your own due diligence, this can come back to bite you in the end.

Are Balloon Payments Legal?

In and of themselves, there’s nothing illegal about balloon payments. There are legal protections in place to keep unscrupulous lenders from taking advantage of borrowers. The Truth in Lending Act, for example, defines a balloon payment as a payment that’s two or more times the ordinary monthly payment, and requires lenders to disclose any such payment to the consumer.

In addition, lenders must inform consumers in advance whether or not the loan can be refinanced, and what the refinancing conditions are. If a lender fails to meet the Truth in Lending Act’s disclosure requirements, they can be held liable for double the amount of the financing charge and any court costs. The lender can also be held responsible for criminal charges and receive up to a year’s imprisonment.

Several states have joined in an interstate compact called the Uniform Consumer Credit Code. This code doesn’t place any limits on balloon mortgages per se, but it does give consumers additional rights. Significantly, they gain the right to refinance the amount of the balloon payment with zero penalty, with interest capped at the same rate as the original loans.

In a few states, it’s also illegal to issue balloon mortgages to individuals with seasonal or sporadic sources of income. In a handful of others, balloon mortgages are outright illegal. In other words, it pays to check your local laws.

Balloon Payments Vs. Adjustable-Rate Mortgages

Balloon loans are often confused with adjustable-rate mortgages (ARMs). However, these are two completely different things. With an ARM, a borrower pays a pre-determined rate of interest for a period of one to five years. At that point, the interest rate is re-calculated based on the borrower’s current credit rating and the current market conditions. Depending on the specific contract, the interest may adjust multiple times over the course of the loan.

That said, an ARM continues to be paid in regular monthly payments, and the mortgage is fully amortized at the end of the loan term. Your interest may go up or down, but you never have to make a single massive balloon payment.

How To Calculate Balloon Payments

Balloon mortgages are given for a certain term, with a separate amortization term. For example, a 7/15 loan would have a term of 7 years, but would only amortize after 15 years. Knowing this information, along with the interest and the loan amount, it’s easy to calculate a balloon payment. But first, you need to know the formula.

The formula to calculate a balloon payment is:

FV = PV*(1+r)n–P*[(1+r)n–1/r]

Here’s a quick explanation of the variables:

  • FV is the final value of the balloon payment.

  • PV is the present value, or the original loan balance.

  • r is the interest rate.

  • n is the total number of payments.

  • P is the amount of the monthly payment.

Does this all sound a bit complicated? It’s easier to understand if we use an example.

Dave borrows $240,000 on a 10/15 balloon mortgage with a 6% fixed interest rate. This works out to a monthly payment of $2,025. So, we know our present value and the monthly payment amount. On a 10-year loan, we also know that there will be 120 monthly payments. This gives us all the information we need to fill out the equation. And with a 6% fixed interest rate, the actual interest rate per month will be 0.5%.

We get:

FV=$240,000*(1+0.005)120-2,025*[(1+0.005)120- 1/0.005]

This works out to:

FV=$104,960

So after 10 years of $2,025 monthly payments, Dave will make a final balloon payment of $104,960.

Disadvantages Of Balloon Payments

During the 1970s real estate boom, balloon payments were part of ordinary, everyday payments. Demand was sky-high, but cash flow was tight, so real estate investors took advantage of balloon loans to obtain a ready supply of financing. Investors would purchase properties with a traditional loan, then immediately take out a second, smaller mortgage in the form of a balloon loan, which required zero monthly payments.

Lenders would allow you to do this back then, and it was an easy way to obtain extra money for renovations. But this only worked for two reasons, both of which were unique to the situation.

To begin with, the second mortgage was only for a small amount – 10% of the purchase price at maximum. So even though there was no money coming into the bank in the form of payments, they were still collecting enough money on the original loan to earn a healthy profit. Meanwhile, interest continued to accrue for a three- or five-year term.

The other reason it worked so well was that property values were rising by more than 10% per year. If you borrowed $10,000 against a $100,000 home, you could easily sell that home for $130,000 three years later – more than covering the cost of the loan.

By now, you may have started to see the problem with balloon loans. They work well under certain conditions, but what happens when the market stalls or takes a downturn? In that case, your smart investment is suddenly a big financial loss. It can also make it impossible for your family to move.

This happened in 2007 when so-called Option ARM mortgages were popular. These mortgages paired interest-only monthly payments with a final balloon payment. They were great news for sellers since financing was so easy to obtain. But when the real estate market crashed, millions of buyers found themselves underwater – owing more for the house than it’s worth.

In this case, you can’t sell your house – at least not without paying a significant penalty. Your only choices are to pay the penalty, pay the balloon payment, or refinance with a traditional mortgage. If you’re unable to do any of these things for some reason, you may face foreclosure.

Can You Refinance Your Balloon Payment?

Yes, you can. As we’ve already discussed, this is the ordinary way people go about paying one off. Unless you’re in a particularly strong financial position, there’s no way most people can afford a balloon payment. After only 5-7 years of repayments, you’ve mostly been paying interest, and a large portion of the balance will still be outstanding. This is something a large business can absorb if they own many properties. But for ordinary individuals, the only realistic choice is to refinance or sell the home before the balloon payment is due.

That said, refinancing is not a sure thing. As with any mortgage, you still need to get approval. Under most circumstances, this won’t be a problem. You already got approved for your original loan, and now that you’ve been making payments, your new loan will be for less money. That said, you still have to maintain good credit, and a sudden drop in income could affect whether or not you can get approved.

Another potential issue is if your home’s value has dropped. If you’re underwater on your existing mortgage, it could be impossible to get approved for refinancing. At this point, it helps to have a strong credit history.

A decline in market value is the most common reason for going underwater on your mortgage, but it’s not the only one. It’s also easy to go underwater if you take out what’s called a negatively-amortizing mortgage. In this type of mortgage, your monthly payments are actually less than the interest. As the loan term goes on, you owe more and more money.

Sometimes, people take a negatively-amortizing mortgage as a way to buy into an otherwise-inaccessible market like San Francisco. The logic is that housing prices are going up so fast in those areas that you’ll be able to refinance later, even accounting for accrued interest. But if the expected gains don’t materialize – even if the value still goes up – you can find yourself underwater when your balloon payment is due.

If you find yourself in one of these situations, call your lender right away, and see if you can negotiate a new payment plan. Foreclosure is messy for the bank as well as for you, and they’ll more than likely be willing to work with you rather than go through that process.

Even if they’re not willing to provide a traditional mortgage, they may be willing to agree to another five- or seven-year balloon mortgage. This will allow you to continue to build equity, so you’ll be more likely to qualify for refinancing in the future. At the very least, you’re less likely to be underwater, so you’ll have more options.

Summary

Balloon mortgages aren’t the best choice for everybody. But they’re an effective way to obtain financing if a traditional mortgage doesn’t work for you. Balloon payments are also popular tools for commercial property owners who want easy financing for renovations. In these and other scenarios, a balloon mortgage can be a useful financial tool.


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