A balloon loan mortgage is financing that includes a lump sum payment in any point of the loan’s terms – typically at the end of the loan.
Balloon Loan Highlights
- A balloon loan can have either interest-only or both principal and interest payment options.
- Regardless of a balloon loan’s options (interest-only or principal + interest), the structure inherently excludes a full payoff through regular monthly payments and as such includes a lump sum payment that typically occurs at the end of the loan.
- A balloon loan that includes principal and interest payments may be structured such that the interest rate is fixed or has an adjustable rate.
- Balloon loans typically are structured to have either five or seven year terms.
- A balloon loan typically does not have a prepayment penalty.
The PROs and CONs of Balloon Loans
- Lower Monthly Payments – a balloon loan has lower monthly payments because the principal is not paid down (interest only) or is only partially amortized (ARM).
- Home Affordability – a balloon loan’s lower monthly payment enables home ownership for those who may not otherwise afford to purchase
- Financial Flexibility in a Short-term Mortgage – In those situations where it is known home ownership will be short term, leveraging a balloon loan reduces the monthly expense and frees up monies for alternative uses, which would otherwise be devoted to a home’s amortization payment schedule.
- Higher Risk for Borrower – to fulfill a balloon note’s lump sum payment a home may need to be sold, monies may need to be saved/available or a refinance strategy may need to be invoked. Each of the above options introduce risk in association with the payment of the lump sum.
- Higher Risk for Lender – the lender takes a higher risk for balloon loans for the following reasons: (a) balloon notes have a higher foreclosure probability due to the outlay of the balloon payment and (b) zero or partial monthly paydown results a higher principal balance than that of a traditional loan over the same timeframe.
- Market Conditions Can Impact Refinance Options – Interest rates on home values fluctuate and can have negative impacts when considering the refinancing of the lump sum balloon payment.
- Traditional Loans Tend to Have Better Rates – traditional loans have lower risk than a balloon loan and thus typically have lower interest rates.
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