A Complete Guide to Balloon Mortgages
Balloon loans: they sound like fun (who doesn’t like balloons?) but they’re sometimes a homebuyer’s worst nightmare.
We’ll break down exactly why in this ultimate guide to balloon mortgages.
When it comes to getting a traditional home loan, most home loans are fully amortized. A fully amortized loan means that each payment a borrower makes goes towards paying off both the interest and the principal. At the end of the loan period, the entire loan is paid off.
A balloon loan is a type of mortgage that doesn’t fully amortize over the life of the loan. That means a borrower is left with a large “balloon payment” due at the end of the mortgage.
What Is a Balloon Mortgage?
A balloon loan is a short-term mortgage. It’s a home loan with a large payment due at the end of the loan. A balloon loan is a type of mortgage that doesn’t fully amortize over the life of the loan. That means it comes with a large “balloon payment” due at the end of the mortgage.
Balloon mortgages often last between 5 and 7 years, yet come with a payment plan typically based on a 15- or 30-year mortgage. Home loans with balloon payments have lower monthly payments in the years leading up when the balloon payment is due.
Unfortunately, the size of many of these payments often makes it difficult (or impossible) for borrowers to pay them off. Many balloon loans have a term of 5 to 7 years (after which the balloon payment is due). A balloon mortgage loan payments are based off a 30-year loan term.
At the end of the mortgage, the borrower still owes the rest of the unpaid principal and is required to pay it as a lump sum. Since most borrowers can’t afford this, they typically either sell the house or refinance the balloon loan before the balloon payment is due.
What Are the Uses for a Balloon Loan?
In many cases, people who take out a mortgage with a balloon payment do not actually intend to pay it off when the time comes. Instead, they’ll often take on the mortgage with the intention of selling the property a for-profit if the price goes up. Or, they may simply refinance their mortgage into a non-balloon home loan before the big payment is due.
Or, in other cases, they simply covert the balloon loan into a conventional 15 or 30-year mortgage. This can make a balloon loan a great way to buy a larger home than you could usually qualify for. A balloon mortgage can also potentially make money off from selling it later (if you can time the market right).
What Are the Benefits and Risks of a Balloon Loan?
Much of the time, balloon mortgages are easier to qualify for than traditional mortgages, and may also have lower interest rates. Despite that, a balloon loan can be a risky proposition. This is especially true if a borrower doesn’t have the funds to cover the balloon payment when it’s due.
And, while many people do plan to refinance their loan before the balloon payment is due, there’s no specific guarantee that a lender will approve your refinance. If you can’t pay, and you can’t refinance, then you could end up defaulting on your loan (and no one wants that!). As an example, let’s take a closer look at the pros and cons of getting a 5-year balloon loan, which has a loan life of 5 years with the balloon payment due at the end of the term.
What Are the Benefits of 5-Year Balloon Loans?
Balloon loans, like the 5-year balloon loan, have various benefits for borrowers. The most popular benefit is they often offer lower interest rates. Additionally, balloon loans are typically much easier to qualify for than traditional, 15- to 30-year fixed rate mortgages.
This can allow younger homebuyers (or those with lower credit scores and little to no savings) to buy a larger and nicer home. It can also be a way to invest in a home that you think will significantly increase in value during the next few years. Despite those benefits, balloon loans aren’t without their fair share of risks.
What Are the Risks of 5-Year Balloon Loans?
The major risk of taking out a five-year balloon loan (or any balloon loan for that matter), is the balloon payment. It can be risky to have to pay out a huge amount of money at the end of the loan. For example, a 5-year, $200,000 balloon loan with a 4.5% interest rate might only have a monthly mortgage payment of around $1,000. However, at the end of the five year period, a borrower would likely owe a balloon payment of more than $183,000. And, unless you’re simply rolling in cash, you likely won’t be able to afford the final payment.
For that reason, the vast majority of balloon loan borrowers do not actually intend to pay the balloon payment at the appointed time. Instead, they usually decide to sell the home, refinance it, or convert the balloon mortgage to a traditional fixed-rate or adjustable-rate mortgage. Some balloon mortgages are built with specific conversion options, like a 5/25 convertible balloon loan or a 7/23 convertible balloon loan. In many cases, you can convert a balloon loan to a 30-year fixed rate loan at the current interest rates, with an additional 0.375% interest increase.
How Large can a Balloon Payment Be?
The size of a balloon payment can vary greatly depending on the terms of your specific loan. Typically, a balloon payment is at least two times the average monthly payment and can range upward into the tens or even hundreds of thousands of dollars.
Who’s the Ideal Borrower for a Balloon Loan?
A balloon loan can be a risky proposition. But, that doesn’t mean it can’t be a good choice for some borrowers. Balloon loans typically have lower interest rates and may be easier to qualify for than most conventional loans. This makes them attractive for borrowers with lower credit, or those who simply want to take advantage of the lower interest rates.
There’s no guarantee that a borrower can refinance their balloon loan before the balloon payment is due. If they can’t refinance, convert to a fixed-rate mortgage, or sell the home, they could default on the loan.
For example, let’s look at a borrower taking out a $200,000 balloon loan with a 7-year term at a 4.5% interest rate. The borrower would owe a balloon payment of more than $175,000 at the end of that 7 years. That’s a lot of cash to cough up at once!
Can Making Prepayments Be Beneficial to a Balloon Loan Borrower?
There’s a great way to ensure you’ll qualify to refinance your balloon loan before the balloon payment is due. You can do this by making additional payments, or prepayments, on the loan. These can typically be made on a monthly basis (by adding a certain amount to your mortgage payment) or on a once-annual basis.
By making these additional payments, you’ll have a lot more home equity when it comes time to refinance. This means your loan will probably have a lower loan-to-value (LTV) ratio. That lower LTV ratio makes it less risky for lenders.
The main thing to watch out for here is prepayment penalties, which are surprisingly common in balloon loans. If your balloon loan has prepayment penalties, it might be a good time to start looking for another loan product. The reason? These penalties might also kick in if you want to refinance your home or sell your home too many years before the balloon payment is due.
For example, you could get charged if you wanted to sell or refinance your home in four years into a seven-year balloon mortgage. That could limit your options and make it much more difficult for you to emerge from your balloon loan financially unscathed.
Can You Refinance a Balloon Mortgage?
Thankfully, you can. And unless you’re simply rolling in dough, you may be forced to refinance. A balloon mortgage is a home loan with a short-term, often 5 – 7 years. When the term is up, the rest of the loan is due in one large payment, called a balloon payment. Of course, most people don’t have this balloon payment sitting in a Swiss bank account somewhere. Before the balloon payment comes due, they usually either:
refinance the loan
convert the loan to a fixed-rate mortgage
sell the home before the payment is due
Being Underwater on Your Home Can Impact Your Ability to Refinance
While refinancing your balloon loan before the payment is due is often the smartest option, it’s by no means guaranteed. Just like with any other home loan, you’ll need to be approved by a mortgage lender. A lender will look at your debt-to-income ratio, credit score, and financial health before deciding to go forward with the mortgage.
One thing that can make it difficult to get a balloon mortgage refinanced is being underwater on your home. This means you owe more on the home than it’s worth. Most lenders like for homeowners to have 20% equity in their home before approving a refinance. If you have negative equity in your home, that’s not going to look good.
Going underwater on your home can happen in several ways: the most common is if you purchased your home right before a period of steeply declining home values. For example, you took out a $160,000 mortgage on a house valued at $170,000. The house’s value has now declined to $140,000. You now would be “underwater” on your home. Even if you sold it for full market value, you wouldn’t be able to recoup your expenses, and would still owe $20,000 to your lender.
Another way that you can potentially become underwater on your home is if your balloon mortgage is negatively amortizing. Negative amortization means you make monthly payments that are less than the monthly interest you owe on your home. In that case, the part of the interest that you aren’t paying gets added to the principal of your loan. While this may not often be the sole reason for a homeowner going underwater, a negatively amortizing loan combined with a small decline in home values just might.
What to Do If You Can’t Refinance a Balloon Loan
Balloon mortgage due and can’t refinance? What do you do? Call your mortgage lender as soon as possible. If you’re lucky, they may deem helping you out more beneficial than allowing your home to go through foreclosure.
In some cases, they may offer you another five years of limited payments before another balloon payment is due. During this time, you may be able to build more equity in your home (and therefore be more likely to get approved for a traditional refinance).
Alternatively, if your home loan is backed by Freddie Mac or Fannie Mae, the Home Affordable Refinance Program (HARP) may be able to help save you from foreclosure. The program expires on December 31, 2018. HARP allows qualified borrowers to refinance their homes, without any loan-to-value (LTV) limits or the requirement of taking on additional mortgage insurance.