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How Does a Balloon Mortgage Work?

By Jamie Cattanach · July 05, 2023 · 7 minute read

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How Does a Balloon Mortgage Work?

A balloon mortgage is where you make low monthly payments for a short period of time, and then pay off the entire loan balance at the end of the term. Balloon mortgages are typically five to seven years, but can be as little as two years. The payments leading up to the final payment, also known as the balloon payment, can be interest-only or principal and interest.

Here, we’re looking at what exactly a balloon mortgage is and how it works, including pros and cons and who may want a balloon mortgage.

What Is a Balloon Mortgage?

A balloon mortgage is a mortgage with a shorter-than-normal term — maybe five or seven years as opposed to 15 or 30 — with relatively low monthly payments but a large lump sum due at the end of the term.

How does this work exactly? In technical terms, a balloon mortgage is one that hasn’t undergone full mortgage amortization. Although the payments are based on a 30-year term, the actual term is much shorter, which means a lot of money is left over at the end (hence the lump payment due).

Typically, people who take out a balloon mortgage plan on selling the home or refinancing before the balloon payment is due. Or, some may expect to receive a large sum of money that can be used to pay off the loan.



💡 Quick Tip: Traditionally, mortgage lenders like to see a 20% down payment. But some lenders, such as SoFi, allow home mortgage loans with as little as 3% down for qualifying first-time homebuyers.

Why Would Anyone Want a Balloon Mortgage?

Being suddenly faced with a lump sum mortgage payment might sound like a nightmare to most of us. So when would such a financial product actually be an attractive option?

It’s worth noting that balloon mortgages often carry lower interest rates than 30-year fixed-interest mortgages, and in some cases, they can be easier to qualify for. That can make them tempting to those in the following situations:

•   The borrower plans to sell the house and move before the balloon sum is due. This way, the lump sum is paid off with proceeds from selling the house — and in the meantime, the borrower benefits from the lower interest rate.

•   The borrower plans to refinance the loan once the balloon sum is due. This is a common scenario, and may give a borrower the opportunity to benefit from the lower interest rate of the balloon mortgage in the short term while buying time to build credit and shop for a better loan in the long term.

•   The borrower expects to have the money to pay the balloon sum by the time it’s due. Maybe they have another property they plan to sell or are banking on an inheritance or some other savings plan — and they might save money in the long run on interest compared with taking out a traditional 30-year mortgage.

That said, there are obviously risks to this approach that may outweigh the benefits.

Recommended: Guide to Buying, Selling, and Updating Your Home

Pros and Cons of Balloon Mortgages

What are the specific advantages and disadvantages of balloon mortgages?

Pros

•   Possible lower interest rate. Balloon mortgages may carry a lower interest rate than mortgages with longer terms, depending on the lender’s criteria and the borrower’s creditworthiness.

•   Possible lower monthly payment. Lower interest rates can translate to lower monthly payments, making the mortgage more affordable and easier to fit into the monthly budget (at least in the short term).

•   May pay off the loan quicker. If a borrower is able to come up with the lump sum payment at the time it’s due, a balloon mortgage may allow a purchaser to pay off the house more quickly.

•   Possibly easier to qualify for. Because of their lower payment, balloon mortgages may be considered less risky to some lenders. This means they can be easier for consumers to qualify for, which may make them a more accessible option for some.

Cons

•   Interest-only payments. In some cases, the monthly payments made during the term of a balloon mortgage may be interest-only — which means borrowers aren’t building equity in their homes during that time.

•   Buyers may be unable to sell their house or refinance in time. To avoid the lump sum payment, borrowers must sell or refinance. If rates have risen or they can’t sell, they may face mortgage foreclosure.

•   Buyer may pay more in fees. Even if successful, refinancing can incur fees that may mitigate some of the savings earned by taking out the balloon loan in the first place.

•   Refinancing may increase monthly payment. After refinancing, monthly mortgage payments are often higher, especially if the balloon mortgage was interest-only.

•   Risky for the borrower. Other unforeseen circumstances can wreak havoc on a balloon borrower’s plans, leaving them with a huge lump sum payment they can’t afford.



💡 Quick Tip: To see a house in person, particularly in a tight or expensive market, you may need to show proof of prequalification to the real estate agent. With SoFi’s online application, it can take just minutes to get prequalified.

Other Types of Mortgages to Consider

Although balloon loans can be relatively easy to qualify for and do have some benefits, in many ways, they can be risky, too. We know what they say about best-laid plans — and even those with bulletproof plans sometimes encounter unforeseen circumstances.

What if the money that was set aside for the balloon payment has to be spent on a medical emergency or another surprise expense? What if the sale of the property or the annual bonuses fall through? What if, when it’s time to refinance, rates are actually higher or the borrower’s credit history is less favorable? What if property values have dropped precipitously and refinancing options are hard to come by?

Fortunately, there are plenty of other types of mortgages that can meet borrowers’ needs without creating an unduly risky scenario.

Fixed-Rate Mortgages

A fixed-rate mortgage, or FRM, is one in which the interest rate is fixed. The borrower pays the same interest rate over the entire term of the loan, usually 15 or 30 years.

The fixed interest rate also means the monthly payment amount is fixed, making this a popular type of mortgage for those who want to plan ahead to ensure that their mortgage payment will fit their budget.

FRMs protect buyers from rising interest rates; no matter what happens with the market, they can rest assured their rates will stay the same.

On the other hand, FRMs can preclude borrowers from benefiting when interest rates drop — which leads us to another popular type of mortgage.

Adjustable-Rate Mortgages

An adjustable-rate mortgage, or ARM, has an interest rate that fluctuates over the term of the loan based on the market. These loans generally begin with a relatively short period when the interest rate is fixed — known as the fixed-rate period — before switching to the variable interest rate.

ARMs are attractive for a variety of reasons. For one thing, the interest rate during the introductory fixed-rate period is often lower than it is in FRMs, meaning the borrower can enjoy smaller payments at the beginning of the mortgage.

ARMs may also allow borrowers to benefit when market rates drop. Though, if market rates increase, so can the borrower’s monthly payment. Some ARMs include clauses limiting the annual and life-of-loan adjustments and creating rate caps, which can help protect buyers, but it’s still not the same kind of peace of mind available from FRMs.

Recommended: Fixed vs. Adjustable Rate Mortgages: What’s the Difference?

More Ways to Find the Right Mortgage for Your Needs

Any mortgage — indeed, any loan — carries some degree of risk. But there are ways to mitigate the inherent hazards involved with owing a large debt.

For one thing, figuring out how much house you can afford is an important first step to help ensure that you don’t overspend and end up with an unaffordable mortgage.

Once you’ve got a home-buying budget locked in, researching types of mortgage loans is a great next step. And finally, shopping around at different lenders for the best mortgage terms available can also help you save money in the long run.

Government-insured loans can help borrowers qualify with low-interest rates and down payments — as little as 3.5% for FHA loans and even 0% for USDA loans in approved rural areas.

But conventional loans, or those offered from private lenders, can also offer competitive terms and incentives.

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*SoFi requires Private Mortgage Insurance (PMI) for conforming home loans with a loan-to-value (LTV) ratio greater than 80%. As little as 3% down payments are for qualifying first-time homebuyers only. 5% minimum applies to other borrowers. Other loan types may require different fees or insurance (e.g., VA funding fee, FHA Mortgage Insurance Premiums, etc.). Loan requirements may vary depending on your down payment amount, and minimum down payment varies by loan type.

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