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How Does a Balloon Mortgage Work?

December 29, 2020 · 5 minute read

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How Does a Balloon Mortgage Work?

When you’re buying a house, it can feel like the jargon never ends—and most of it isn’t exactly fun sounding. Fixed-rate vs. variable-rate mortgages, loan-to-value ratios and cost of funds index … isn’t it bad enough to have to remember the fancy names from all those paint chips?

There is one colorful-sounding piece of home loan lingo you may have yet to encounter, however: balloon mortgage. What exactly is a balloon mortgage, and how does it work? When is it a smart money move, and when is it a great big mistake just waiting to burst?

What Is a Balloon Mortgage?

Despite its festive terminology, a balloon mortgage is slightly less exciting than getting a handful of floating, colorful baubles at a party.

Basically, it’s 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).

Let’s say you take out a mortgage of $250,000 with a 4.5% interest rate and a seven-year term. You might make a monthly mortgage payment of about $1,300—but owe a balloon payment of more than $218,000 once the term was up.

Recommended: Home Loan Help Center: What to Know about Mortgages in 2021

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.

Pros and Cons of Balloon Mortgages

What are the specific advantages and disadvantages of balloon mortgages?

Pros:

•   As mentioned above, balloon mortgages may carry a lower interest rate than mortgages with longer terms, depending on the lender’s criteria and the borrower’s creditworthiness.
•   Lower interest rates can translate to lower monthly payments, making the mortgage more affordable and easier to fit into the monthly budget.
•   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.
•   Because of their short term, balloon mortgages are often considered less risky to lenders, which means they can be easier for consumers to qualify for, which may make them a more accessible option for some.

Cons:

•   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—or may find that interest rates have risen and they can’t refinance favorably.
•   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.
•  After refinancing, monthly mortgage payments are often higher, especially if the balloon mortgage was interest-only.
•  Other unforeseen circumstances can wreak havoc on a balloon borrower’s plans, leaving them with a huge lump sum payment they can’t afford.

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?

All these risks are one reason balloon payments generally aren’t allowed in qualified mortgages, which are home loans wherein the lender goes to more strenuous lengths to qualify the borrower.

Qualified loans were created as part of the Dodd-Frank Act of 2010, which was passed to help avoid a repeat of the 2008 housing bubble crisis—which is also why balloon mortgages can be more difficult to find these days in the first place.

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 is one in which the interest rate is, well, fixed, meaning 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 rate 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 ARM interest rate 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, obviously, 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 actually afford is an important first step to help ensure that you don’t overspend and end up with an unaffordable mortgage. For some guidance on budgeting, using a Home Affordability Calculator may be useful.

Once you’ve got a home buying budget locked in, researching types of loans—as you’re doing by reading this article—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.

SoFi, for example, offers a range of fixed-rate home loans—10-, 15-, 20-, and 30-year terms are available—that ensure borrowers regular, unchanging monthly payments and require as little as 10% down.

Borrowers are guided through the process by a team of mortgage loan officers (MLOs—there’s that mortgage lingo again), and SoFi members are eligible for an exclusive discount on their processing fees.

Finding your rate won’t affect your credit score† and takes about two minutes. And you can do it from the comfort of your own couch.

Find out your rate on a fixed-interest mortgage today.



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