Balloon home loans: good or bad?

While approximately 95 percent of all mortgage applications are for fixed-rate loans when interest rates are low, some homeowners who are refinancing choose an alternative form of financing their home. Mortgage lenders offer a variety of options such as adjustable-rate mortgages (ARMs) and balloon loans to meet the needs of individual borrowers. Understanding the details of each loan type can help you and your lender choose the home loan that works for your circumstances.

What is a balloon loan?

A balloon loan is a short-term mortgage with a fixed interest rate and fixed monthly principal and interest payments based on a 30-year amortizing schedule similar to a 30-year fixed-rate mortgage. At the end of the term, which typically lasts for three, five or seven years, the outstanding balance (the "balloon") must be repaid.

If you have not sold the home when the initial term of the loan ends, you must refinance the loan if you have not accumulated the cash to pay the balloon in full. For example, if you agree to a seven-year balloon loan on a $200,000 home and you have paid $40,000 on the principal during the loan term, you will need to pay the remaining $160,000 or refinance that amount when the home loan is due.

Balloon loans with a refinance option

Some lenders may offer a balloon loan with a refinancing option that allows the borrowers to convert the mortgage into another fixed-rate home loan at the end of the balloon period. The new loan would be set at the current interest rates at the time of refinancing, so there is a risk that interest rates could be significantly higher and therefore the monthly payments would rise.

The advantage of a loan with a refinancing option is that the borrowers may be able to qualify for the loan without a reapplication and without needing a new appraisal on the property. Only consider this option if you are prepared for a potential increase in your future loan payments.

Benefits of a balloon loan

While there are clearly some risks associated with a balloon loan, there are also benefits for borrowers with specific circumstances. The starting interest rate on a balloon loan is usually lower than a traditional fixed-rate home loan. It's also usually lower than typical rates on an ARM, allowing you to save money on interest and have smaller monthly mortgage payments at first.

If you are certain you will sell your home before the balloon loan comes due, or if you can count on receiving a large sum of money that can be used to make the balloon payment, you could benefit from the low interest rate of a balloon loan. Investors who are purchasing, rehabilitating and then selling homes within a few months or a year may also want to consider the benefits of a balloon loan to keep payments low.

Another potential advantage of a balloon loan compared to an ARM is when rates are falling. When it's time to refinance the balloon loan, you will pay market rate mortgage interest. ARM borrowers are restricted by their loan terms when their rate adjusts, which could limit how low the rate could go.

Dangers of a balloon loan

Balloon loans can be risky if you intend to stay in your home beyond the initial loan term. These loans are meant for short-term financing. If you cannot refinance due to poor credit, a high debt-to-income ratio or a lower home value when the balloon payment is due, you run the risk of losing your home if you do not have the funds to pay the balance of your mortgage.

While balloon loans are often considered risky for most homebuyers, these loans carry advantages for you if you are certain you will own the home for a short period of time or if you know you will have the cash and want to use it to pay off the home loan when the balloon payment is due. If you are considering a balloon home, you need to weigh the risks and benefits to see if this loan product fits your circumstances.