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Key takeaways
- A balloon mortgage involves making small payments for a set period, followed by one large balloon payment at the end of the loan term.
- Balloon mortgages can be risky for borrowers, as they may struggle to make the large balloon payment at the end of the loan term.
- Other mortgage options, such as conventional loans or FHA loans, may be better suited for those looking for lower monthly payments without the risk of a large balloon payment.
A balloon mortgage is a type of home loan in which you make low or no monthly payments for a short term, usually five or seven years. After this low- or no-payment period ends, you pay a large lump sum, which settles the remaining balance in full. Because they don’t require much outlay right away, balloon mortgages can be tempting — but they can easily explode on you. Here’s what this kind of loan is all about, from the risks to the rewards.
What is a balloon mortgage?
With a balloon mortgage, you make small payments for a defined period of time, then one large balloon payment. The initial payments might go solely to interest or to both interest and the loan principal, depending on how the mortgage is structured. The large balloon payment can be thousands or tens of thousands of dollars, and generally more than two times the monthly payment, according to the Consumer Financial Protection Bureau.
Most balloon loans require you to pay the remaining balance of the loan as the balloon payment.
Bankrate insights
Balloon mortgages are considered non-qualifying or non-conforming loans. That means they fall outside the criteria set by the Federal Housing Finance Agency (FHFA), and so major market makers Fannie Mae and Freddie Mac won’t buy them from lenders. It’s for this reason that many banks and mortgage companies don’t offer balloon mortgages.
Types of balloon mortgages
A balloon mortgage can be structured in several ways:
- Balloon payment: In this case, the initial monthly payments might be calculated based on a typical 15-year or 30-year amortization schedule, even though the loan term might only be for five or seven years. When the term ends, you’d need to pay the remaining balance in one lump sum. In another version of this type of structure, you make payments on a fixed-rate basis for a period of time, then your rate increases.
- Interest-only payments: In this scenario, you only pay interest for an initial period. Once that period’s over, you owe the remaining balance of the loan.
- No payments: For this type, you won’t make any monthly payments for a very short term, but you’ll accrue interest. Once the term’s up, both the interest and principal are due in one large payment.
When is the balloon payment due?
Under the terms of a balloon mortgage, the balloon payment is due on the loan’s maturity date. For instance, if you take out a 10-year balloon mortgage, the balloon payment is due once the 10 years have elapsed.
If you’re uncertain about when your balloon payment is due and how much it will be, you can find this information by looking at your mortgage note.
Pros and cons of a balloon mortgage
Pros of balloon mortgages
- Low or no monthly payments: You might have to pay only interest during the initial period, or make low or no monthly payments at all.
- Can defer payments for years: Although you’ll be required to repay the full balance of the loan in a lump sum payment, you can put this off for several years.
- Can buy a home sooner: You could get into a home sooner thanks to more affordable monthly payments.
- Can focus on other goals: If you plan to refinance before your balloon payment is due, you can focus on saving money, building your credit score or achieving other financial goals now.
- No prepayment penalty: There’s usually no prepayment penalty on a balloon mortgage, so you can make extra payments or pay it off before it matures without incurring a fee.
Cons of balloon mortgages
- Risk to home: Because you need to make a lump sum payment when the loan comes due, you’ll either need to save enough cash, refinance or sell the home. None of these options are guaranteed, and if you can’t make the payment, you could lose the home and severely damage your credit.
- Deeper debt: In order to cover the steep cost of the balloon payment, you may need to obtain another loan if you don’t have the cash set aside.
- Hard to find: Due to the level of risk, many mortgage lenders don’t offer balloon loans.
- Higher rates: Lenders take on more risk with a balloon loan, so the rates are typically higher compared to traditional types of loans.
- Difficulty refinancing: If you’re not making payments (or are making interest-only payments), you might not have enough equity in your home to do a refinance when the balloon mortgage term is up. (Most lenders look for at least 20 percent home equity.)
How to pay off a balloon mortgage
There are four primary ways to pay off a balloon mortgage:
- Pay off the mortgage: If you can afford it, the simplest — but priciest — option is to save enough money to pay the remaining loan balance in full when it’s due. This route is best reserved for those who anticipate a windfall (such as an inheritance) or a substantial increase in income before the balloon payment comes due.
- Make extra payments: Paying down your loan principal more aggressively with extra payments during the initial period reduces the remaining balance due at the end of the loan term. If you have extra income each month or get a large tax return, consider directing some of the funds to your mortgage principal.
- Sell your home: If you were to make improvements to the home and sell it by the time you need to repay the balance in a lump sum, the proceeds from the sale could provide you with enough cash to make it happen.
- Refinance: If you don’t have enough cash to make the balloon payment, you can see if you’ll qualify for a refinance. To qualify, you’ll need an adequate credit score (at least 620), proof of steady income and at least 20 percent equity in your home. If you don’t have enough equity, you can explore low- or no-equity refinance options. You’ll also need to consider how the new payment impacts your budget. If you were enjoying low monthly payments with the balloon mortgage, refinancing to another loan could increase those payments significantly.
Balloon mortgage FAQ
Because they are riskier products, balloon mortgages tend to have higher interest rates than traditional fixed- or adjustable-rate mortgages (ARMs). However, the interest rate on a balloon mortgage might be lower than the rates on other options at first, and you might not have to pay interest at all initially.
Balloon mortgages differ from other mortgages in other ways as well. For instance, not all lenders offer balloon mortgages. Often, these types of mortgages can only be found through small or private lenders, as they don’t conform with qualified mortgage guidelines. Additionally, the eligibility criteria for balloon mortgages may be slightly different than a traditional mortgage.
Balloon mortgages often appeal to a specific category of borrowers, including property flippers, real estate investors and certain homeowners — like those anticipating an inheritance or other major cash windfall. These individuals typically foresee a substantial increase in their income, plan to sell their property before the balloon payment is due or anticipate they will be able to settle their debts or acquire funds from other sources.
While a balloon mortgage might make sense for some people, like house flippers, there are also some risks associated with balloon mortgages, including defaulting on the loan if you’re unable to make the balloon payment at the end of the loan term. In such cases, your lender will likely take steps to foreclose on your home. You’ll also build equity more slowly, so you may not make a huge windfall when you eventually sell it, if your loan is still unpaid at that time.
In addition, if you’re counting on selling the home to make the balloon payment, there’s also the risk of a real estate market downturn that leaves you unable to fetch a high enough price to pay the full amount due.
For potential homeowners who want to limit their initial costs, an FHA graduated payment loan or VA loan may be a better option. Both are government backed and include a low or no down payment scheme to reduce upfront home ownership costs for borrowers.
Balloon mortgages pose a risk for lenders largely relying on the borrower’s ability to make a large one-time payment at the end of the loan term. If the borrower’s financial situation deteriorates, or the value of the property decreases, they might struggle to sell or refinance the property to meet the balloon payment and default on the loan. This risk is heightened due to the possibility that the borrower may only be making payments toward the interest, or making minimum payments throughout the loan term.
Conventional mortgages are one alternative to balloon mortgages, which come with the option for a fixed- or adjustable-rate mortgage. A fixed-rate mortgage offers stability with the same monthly payment over the life of the loan. Adjustable-rate mortgages (ARMs) could be a good fit for those intending to refinance or sell before the low introductory interest rate adjusts. For borrowers with lower credit scores, FHA loans can provide government-backed financing that’s easier to secure.
