When considering home loan options, you may come across something called a balloon payment. A balloon payment is often tied to a balloon loan, which can have lower initial payments than a traditional loan but can also increase your risk as a borrower.
Before accepting a loan with a balloon payment, make sure you know the risks and understand your options when the loan must be repaid.
What Is a Balloon Payment?
Most balloon loans require a balloon payment, a large lump sum due at the end of the term to pay off the balance. This final amount is often more than two times your loan’s average monthly payment.
Monthly payments are usually lower for a balloon loan than a traditional 30-year mortgage because the lender accepts interest rate risk for, say, 10 years instead of 30, says Evan Swanson, mortgage professional at Cherry Creek Mortgage.
“In other words, from the lender’s perspective, they are guaranteed to receive their loan amount back within 10 years,” Swanson says. “Assuming interest rates rise over the initial 10-year period, lenders are then able to re-lend the money for a higher interest rate.”
From the borrower’s perspective, the trade-off for lower monthly payments can be the substantial balloon payment. Swanson gives the example of a 30-year $100,000 loan with a 3.5% interest rate versus a 10-year balloon mortgage.
“The borrower’s monthly payment is based on the amount needed to pay the loan off over a 30-year term,” which in this case is $449.04, he says.
You will make the same monthly payment with the balloon loan but owe a balloon payment of nearly $78,000 unless you refinance at the end of 10 years.
Note that balloon payments are not allowed for most qualified mortgages, which cannot include certain risky loan features.
How Is a Balloon Loan Different From Other Home Loans?
The main difference between a balloon loan and other home loans is that the former leaves the borrower with a principal balance at the end of the term and the latter is fully repaid through amortization. The amortization process spreads out principal and interest over time to pay off debt.
Another difference is that a balloon mortgage has a much shorter term of five to 10 years compared with 30 years for a traditional mortgage.
“If you have a seven-year balloon, you will enjoy a monthly payment based on a 15- or 30-year amortization,” says Carolyn Morganbesser, senior manager of mortgage originations at Affinity Federal Credit Union. “But at the end of seven years, your loan is due.”
You might pay interest only each month or a portion of interest and principal, but either way, you will owe a lump sum at the end of a balloon loan.
What Are the Pros and Cons of a Balloon Loan?
- Interest rates. Balloon loans can have lower interest rates than standard fixed-rate loans because balloon loans must be paid back faster, which means they can be less risky for lenders.
- Monthly payments. Paying little to no principal translates into a low monthly payment until the balloon payment is due.
- Loan amount. A balloon loan may allow you to afford more house or get into a home sooner than you would have otherwise.
- Large final payment. This can be tens of thousands of dollars.
- Risky. If you can’t make the balloon payment, refinance or sell the home, you could lose the property to foreclosure and damage your credit.
- Low equity. You will accrue little to no home equity if your monthly payments are mostly or entirely interest, and refinancing could be difficult.
How Do You Qualify for a Balloon Loan?
If your income or credit is lacking, a balloon loan may not be for you. This high-risk loan requires an excellent credit score, a large down payment and a substantial income.
Overall, the qualification process for a balloon loan is similar to the process for a traditional loan. The lender will ask for proof of income and check your debt-to-income ratio and credit to determine your ability to repay the loan.
“To apply for a balloon loan, you must apply for any of the mortgages mentioned in basically the same way,” says Lamar Brabham, CEO and founder of Noel Taylor Agency, a financial services firm in North Myrtle Beach, South Carolina.
How Can I Calculate My Balloon Loan Payment?
The easiest way to calculate your balloon payment is to use a free online balloon payment calculator from one of many bank websites.
Calculators usually require home price, down payment amount, loan term and interest rate to compute your monthly payment and your balloon payment.
How Can I Pay Off a Balloon Loan?
Ultimately you need cash to make the final balloon payment. You have three options: Save, sell or refinance. Whatever you choose, make sure you have a repayment plan before you apply for a balloon loan.
Save: If you can, save enough money to pay the loan balance when it comes due. This is best if you earn a substantial income or expect an increase in income before you make the payment.
Sell: A home will often be sold before the balloon payment is due, and the sale proceeds can be used to pay off the loan.
Refinance: If you want to keep your property, you could refinance the balloon loan by using the proceeds from a second loan to make the balloon payment. This is the most common practice for borrowers who don’t want to sell, Brabham says.
Should I Get a Balloon Loan?
- You have enough money to cover the balloon payment or are confident that you will receive a lump sum, such as a bonus or inheritance, before it is due.
- You’re seeking short-term financing and plan to sell or refinance the home before you owe the balloon payment.
- You are certain that you won’t stay in the home for long and will sell it before you have to pay the lump sum.
Balloon loans can seem appealing given their low monthly payments initially, but they aren’t for everyone. Most borrowers today opt for fixed-rate mortgages because rates are near historic lows, Woods says.
“Balloon loans are typically offered for higher-risk lending scenarios, where the lender doesn’t want to offer long-term financing based on the situation at hand,” Woods says.