A balloon payment mortgage is an exotic mortgage that doesn’t fully amortize at the time of the loan, thereby leaving a balloon payment at maturity. The balloon payment is also known as a balloon loan because of its high amount at maturity. Balloon payment mortgages are quite common in commercial real estate than on residential real estate.
Commercial mortgage lenders usually set balloon payments at twice the gross income of the property. This provides the lender with a means to stay in business longer and make a profit. Many borrowers don’t realize that there is no specific limit to how much the balloon payments can be until the loan matures. As soon as the loan matures, the lender can then adjust the balloon payments to the market rate. This allows the borrower to either pay less or more each month.
While this strategy does provide some stability for the lender and the borrowers, it can also result in financial distress for the borrowers. Balloon mortgages have a negative connotation among homeowners because of their tendency to leave borrowers “under water.” If interest rates go up, homeowners face the prospect of balloon payments becoming out of control. When mortgage rates decline, however, they are suddenly available to homeowners.
Homeowners who refinance using balloon payment loans don’t always benefit from this strategy. Balloon mortgage loans are not a good choice for borrowers who anticipate high interest rates after the loan is refinanced. These high interest rates can prove costly. As a result, these loans may not be a smart choice for borrowers who plan on living in their residence for several years. If the loan to refinance is for a shorter term, such as a year, this option can be a good choice, however.
With a balloon loan, the borrower has paid interest for a long time, but now stands to pay more. Most financial experts recommend that this type of mortgage be used only when the borrower has reasonable cause to expect interest rates will stay high. The reason for this is that lenders do not like to write off a balloon payment. They would rather give the borrower the money than write off the balloon of their loan.
A 30-year fixed rate mortgage has a balloon payment in case of a downturn in the economy. Mortgage rates typically drop in recession, but when the economy recovers interest rates will likely go up. If a homeowner refinances their home in a recession, the first monthly payment could be several thousand dollars higher than it would be under a conventional loan with a fixed term and a longer term. Although the monthly payment might be higher in this case, it will be much easier to repay and most mortgagees will not penalize the borrower for a balloon payment.
Balloon payment mortgages also come in two types: a seven-year fixed interest rate and a seven-year amortization balloon payment mortgage. A seven-year fixed interest rate loan is where the borrower pays interest for a full seven years until the entire loan is repaid. A seven-year amortization balloon payment mortgage is where the borrower pays interest for a specific number of years, usually five, then the full amount is due. Both types are recommended for borrowers who are able to pay their debts within a reasonable amount of time. If they can do so, a seven-year fixed interest rate loan is preferable; however, if they cannot do so, the seven-year amortization balloon payment mortgage may be a better option.
Regardless of which type of balloon payment mortgage is chosen, it is important that borrowers make all their payments on time. Paying off debt early helps avoid foreclosure and keeps the homeowner from being assessed additional late fees. Many people get into trouble by ignoring their debts or paying their creditors late. If the borrower does not have enough money to make the required monthly payments, the result can be foreclosure, which happens more often in homes that are underwater.