Heed These Warnings from Lenders Before Opting into This Unique Mortgage Feature
Balloons are a mainstay of celebrations of all kinds. They inject fun into birthdays, graduations, and other parties. But when it comes time to apply for a mortgage, you should probably skip the balloons.
There’s such a thing as a “balloon payment” in the mortgage world, and it’s the opposite of fun. The payment works like blowing up a balloon does — it starts off easy enough, but as you keep going, you realize there’s the potential for the balloon to burst. If and when it does burst, things could go south pretty quickly. Here’s what to know before considering one.
What is a balloon payment mortgage?
Todd McCotter, senior vice president at First Reliance Mortgage in Mount Pleasant, South Carolina, explains that a balloon payment mortgage is similar to a regular mortgage, but with a big (and sometimes unpleasant) surprise at the end.
“It is a typical or a traditional mortgage for a set period of time, usually five to seven years; however, it typically amortizes over 30 years,” he says. In other words, it allows for the same type of fixed mortgage payment you’d enjoy with a 30-year mortgage, but the life of the loan only lasts for seven years.
When that five-to-seven year period is up, whatever remaining balance you have left is due — as in immediately due. “That remaining balance due is the ‘balloon’ part of the loan, and depending on the amount of your mortgage could equal several thousands of dollars,” McCotter says.
McCotter points to an example: If you apply and are approved for a balloon loan for $200,000 with a term of seven years and an interest rate of three percent, the typical amortization period of said loan would be 30 years.
“After the seventh year, or 84 months, of payments, you would still owe roughly $167,900 — and would need to pay it in a lump sum or balloon payment,” he explains. So, you’re paying all the money that you would have owed over the remaining 21 years in a lump sum.
Advantages of a balloon payment mortgage
It’s hard to see why anyone would willingly choose this type of mortgage. But McCotter says it might make sense for some homeowners.
He says that balloon mortgages tend to have lower interest rates because the borrower is accepting more risk and agreeing to pay the mortgage off in such a shorter period of time.
“Homeowners who only plan on living in a home for a shorter period might consider a balloon-type mortgage,” he says, since the homeowner could sell the home before the balloon payment is due. “Another client profile for this type of loan would be someone who receives a large bonus, commission, or other compensation in addition to their base salary and also has a financial plan to repay the mortgage prior to the balloon payment.”
According to Julie Aragon, owner of the Julie Aragon Lending Team in Los Angeles, developers and house flippers are fans of these types of loans. “That’s because the payments are so low — sometimes interest-only payments — and these borrowers fully expect to sell the property before the term is up.”
Using a balloon payment mortgage allows them to maximize the capital they have on hand to invest. “These loans are also more popular options for people who wouldn’t normally be able to get conventional financing — for example, if they are in the middle of repairing their credit,” Aragon says.
Disadvantages of a balloon payment mortgage
If you think this sounds like financial Russian roulette you’re not alone. Suppose you don’t get that bonus or commission at work, or your rich relative doesn’t put you in the will?
“The absolute number one risk of a balloon mortgage is not being able to repay the mortgage prior to the balloon payment due date,” McCotter says. “There could be many factors as to why: loss of employment, shift in economy, the pandemic, and more.”
You could refinance the mortgage to repay the balance due — but that’s also a risky proposition. “Even in this scenario, the homeowner has to have the equity position in order to qualify and be able to financially qualify for the new mortgage,” McCotter explains. Plus, by the time you refinance, interest rates may have increased, Aragon warns.
There’s also the option to sell the house if you can’t pay the balloon payment, but if the market shifts to favor buyers, you might have to reduce your asking price.
“If there is no option to refinance the mortgage or sell the home, a balloon mortgage client would have to partner with the current mortgage holder and see if there is an option to extend the terms of the balloon mortgage,” McCotter says. He warns that this would need to be addressed before the balloon date. “If the date of the balloon payment has passed, you are now in default and a lender can begin the foreclosure process.” Yikes! No balloon-filled celebrations there.