Balloon Payment Mortgages
There are a number of options available when it comes to mortgages, each designed to meet the varying requirements of property buyers. One of the less common options is a balloon payment mortgage or a balloon mortgage.
There are both advantages and disadvantages to this type of property financing option and understanding how it differs from a regular home loan or mortgage as well as when it is most beneficial is important.
How Does A Balloon Mortgage Work?
Similar to a traditional fixed mortgage, a balloon mortgage will have monthly installments that are charged at a fixed interest rate. This installment arrangement will, however, expire after a specified period of time (normally between 5 and 7 years) when the outstanding balance will become due, in full (balloon payment). In other words, the mortgage functions like a long-term loan for the first few years and then acts as a short-term loan.
How Does A Balloon Mortgage Differ From A Traditional Mortgage?
With a conventional fixed rate mortgage, the principal amount of the loan including interest will be divided into monthly repayments that will be spread over the entire term of the loan. This is referred to as amortization and once you have paid off the very last installment, the loan will be repaid in full and you will owe nothing. When the entire loan amount is spread over the term, it is referred to as a fully amortized loan.
The balloon mortgage is only partially amortized which means that only a portion of the principal loan amount will be spread over a relatively short loan term rather than the full amount. The balance of the loan that is not amortized will need to be settled in one lump sum. This lump sum is normally a rather large settlement amount and may even be equal to or in excess of the amortized portion or principal loan amount depending largely on the length of the mortgage the term.
Unless a property buyer is expecting a large income in the period before the balloon payment becomes due, most buyers cannot afford a huge settlement in a few years after taking out a mortgage. This makes it an unsuitable option for most people seeking finance and could result in the need to refinance the property purchase when the term of the loan expires. If you cannot afford to make the balloon payment or to reset or refinance the loan, the property will go into foreclosure.
The Reset Option
It is advisable to choose a balloon payment mortgage that has a reset option available to you. This allows you to convert the mortgage into a fully amortized loan once the original term of the loan has expired. The loan provider will recalculate the interest rate and repayments over the new term. This is basically a refinancing option but it is important to be aware that the terms and conditions of the loan may not be as advantageous as other refinancing options.
Also referred to as a convertible balloon mortgage, a shorthand system is used to explain the reset option. For example, a reset option over a 30-year term may be written like this – 5/25. This means that you have five years of installments at the interest rate that was originally offered until you have the option to convert the mortgage. If you choose to reset the mortgage, the outstanding balance of the loan will be spread over the remaining 25 years of the original 30-year term at a new interest rate.
A new interest rate is generally calculated according to current rates and could, therefore, be lower, the same as or higher than the previous rate. Interest rates for other types of refinancing options may be lower.
Advantages, Disadvantages And When To Use A Balloon Mortgage
Although the loan structure may seem complicated at first, there are advantages to a balloon payment mortgage and situations which make it the ideal property financing option. For example, these loans often offer a low-interest rate and they are highly suitable for purchasing property with a quick turnover in mind. In other words, if you are planning to renovate and sell your house for a profit within the first few years.
- Interest rates are lower than conventional mortgages with fixed rates
- It is often simpler to apply for and be granted a balloon mortgage
- Charges associated with closing are often lower
- The loan can be converted if necessary
- If the final balloon payment cannot be made, the property may go into foreclosure if no reset option is available or the loan cannot be refinanced.
- Not all financial providers offer balloon mortgages
- Resetting the loan may not be as beneficial as refinancing or applying for a conventional mortgage option in the first place.
- There is a high probability that a higher interest rate will apply when the loan is reset/refinanced.
While balloon payment mortgages were largely only available to property investors in the past, they have become an option that is now available to homeowners. However, it is very important to take into consideration both the pros and cons of this type of mortgage and understand that this finance is not suitable for all home buyers under all conditions. While the lower interest rate can be highly attractive, keep in mind that refinancing at a later date is not ideal. It is best to use a balloon mortgage when you have a high probability of being able to settle the full loan amount by the end of the original term of the loan.
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