How does a balloon loan work?
In a balloon mortgage loan, you’ll make small monthly payments for a defined period. After this period is over, your balloon payment is due. This is a large, lump-sum payment, typically the balance of the loan.
While a traditional mortgage offers terms of up to 30 years, a balloon loan is usually much shorter — roughly five to ten years, though some longer terms may be available. This means that borrowers may enjoy low monthly mortgage payments for the majority of their loan term, only to be faced with a massive balloon payment at its conclusion.
Balloon mortgages may also have higher interest rates than fixed or adjustable-rate mortgages. Lenders will typically have stricter credit score requirements for applicants, which may make it more challenging to secure a balloon loan compared to other types of real estate financing.
Calculate a balloon payment
How do you know how much the balloon payment will be? The answer depends on the way your balloon loan is structured. The following are three types of balloon mortgages, each of which offers its own way of calculating your final payment.
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Some mortgage lenders may offer a balloon loan with no payments required — though you’ll still accrue interest. You’ll pay nothing during the loan term itself, then pay the full principal amount plus interest once the term concludes.
This balloon payment is easy to calculate. You’ll simply take the purchase price of the home and add on any interest you generate throughout the loan. For example, imagine that you purchase a home for $300,000 with a loan term of 10 years and a fixed interest rate of 7.88%. Once your loan term is up, you’ll owe a total of $434,551, which represents the home price plus 10 years of interest.
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In an interest-only payment structure, borrowers will only pay interest on the loan during the loan term. At the end of the loan term, the borrower will be responsible for paying the principal of the loan.
Assuming you pay all of the interest on the loan, your balloon payment will simply be the purchase price of the home itself. If you purchase a home for $300,000 with a loan term of 10 years and a fixed interest rate of 7.88%, you’ll make monthly payments of $1,121 (to cover the interest), after which you’ll pay the principal in a lump sum of $300,000.
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This structure is the most straightforward. A borrower will make monthly payments according to the payment schedule. At the end of the loan term, a single lump-sum payment is due for the remainder of the loan.
Depending on your lender, you may be making monthly payments that reflect a 30-year loan, even though your actual loan may be much shorter. If you purchase a home for $300,000 with a loan term of 10 years and a fixed interest rate of 7.88%, your total amount will be $434,551. But you’ll be making monthly payments of only $2,176 for the 120 months of your loan term — leading to a total of $261,120. At that point, you’ll owe the difference on the loan, which in this case comes to $173,431.
Balloon mortgage pros and cons
What are the pros and cons of a balloon mortgage loan? Here are some things to consider before you enter into this type of home loan.
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Pros
Positively, a balloon mortgage offers many distinct advantages:
- Low (or no) monthly payments for the duration of your loan
- The money you save on monthly payments can be used for other expenses
- Lower monthly payments make it easier for first-time homebuyers
The primary benefit is that the smaller payments will give you extra cash flow during the loan term. That might buy you time to focus on repaying an auto loan or completing another project — then you can take care of your home loan when the term expires.
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Cons
Despite the financial flexibility of a balloon mortgage, there are some serious drawbacks:
- The balloon payment can be tens of thousands of dollars (or more)
- Life circumstances or the housing market could change, making your plan to pay off the balloon payment impossible, putting you at risk of foreclosure, and ultimately losing your home
- The balloon payment may cause you to seek out another loan to cover it
- Balloon mortgages typically require a higher credit score than traditional loans
In other words, balloon loans are a trade-off. Sure, you get access to low-to-no payments during your loan term. You just need to have a plan in place to deal with the balloon payment after the loan.
How to pay off a balloon mortgage
There’s more than one way to handle the balloon payment. Here are some of the most common ways to pay off your balloon mortgage.
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The most direct way to pay off a balloon mortgage is to simply save your money each month, and then be prepared to pay your remaining balance when the balloon payment is due.
If you’re wise about saving and investing during your loan term, this can be a good option. But make sure you have a secure financial plan. Otherwise, you risk not having enough to cover the loan, which can lead to foreclosure.
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Balloon mortgages are also ideal for those expecting a future financial windfall. For example, if you’re expecting an inheritance, you might use a balloon loan to purchase the home, and then pay the balance once you receive the money. Just plan well to account for taxes and other fees that may affect your available cash.
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You also have the option to sell the home before your loan term expires. You can use the proceeds from the sale to pay the balance on the balloon loan. That’s a common strategy for real estate investors, who use balloon loans to keep costs low when renovating a home and then flip the home for a profit.
The only downside is that the real estate market can cool during your loan term — this may create a gap between your selling price and the balance of the loan.
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Another option is to convert the loan from a balloon mortgage to another type of home loan. The only catch is that you’ll typically need strong credit and steady income.
That can be tough with a balloon mortgage, but you may be able to explore low- or no-equity refinancing options.
Also, the loss of equity due to accrued interest. You can lose existing equity gained from your down payment or payments – if the value of your home declines, it may negate any equity you had, making it difficult to refinance. Just remember that your new loan may bring a substantial increase in your monthly payments.
Balloon mortgages aren’t easy to find since they don’t meet qualified mortgage (QM) requirements. Non-QM loans have features that increase the risk of default. The rules for QM loans were established by Congress and the Consumer Financial Protection Bureau (CFPB) after the global financial crisis that started in 2007.
Is a balloon loan right for me?
Are you thinking about buying a home? A balloon loan can be a great loan option if you plan to deal with the remainder of your loan. It’s also a good strategy for house flippers or other real estate investors.
Otherwise, there are still several loan options out there, including low-cost options for first-time homebuyers. When you’re ready to explore your loan options, a mortgage lender can help you find a plan that’s right for you.
