The typical mortgage loan lasts 30 years and is amortized equally over that entire period, so that the borrower makes consistent payments, including both interest and principal. The last payment pays off the loan. However, there is a type of loan called a balloon mortgage that only lasts five to seven years and requires little or no payments for most of that time. Here’s how they work and when one might be right for you:
What is a Balloon Mortgage?
A balloon mortgage is a short-term home loan that may require small or no monthly payments for the whole loan term, somewhere between five and seven years. At the end of that period, the entire remaining loan balance is due. For example, if you take out a $300,000 balloon loan for seven years at 3.5%, you’ll pay just $1,347 each month, but at the end of that time you will have to come up with $256,481 all at once. That is an insane amount of money, and it might seem like it would never make sense to take on that type of risk, but it actually can be a smart move in some situations.
Why Use a Balloon Mortgage?
There are at least four scenarios when a balloon loan might be the best option:
- You purchase the house to flip it quickly for a profit. You will not need to hold the loan for more than a year in most cases, and if the flip is done properly, the sale price should more than cover the balloon payment.
- Your credit is not good enough to qualify for a traditional loan, but you are already taking steps to improve your score. If it increases significantly, you will be able to refinance into a safer loan within a few years, while still enjoying the benefits of homeownership now.
- You anticipate moving anyway within the next five years. A balloon loan would allow you to make minimal monthly payments, so you can save up for the next house.
- You believe mortgage interest rates will drop dramatically over the next few years and you want to pay similar mortgage prices until then. You would have to time the market right to refinance before your loan comes due.
There are some obvious risks with taking out a balloon loan. Whether you plan to sell or refinance or even save up all the money in cash before it comes due, there are no guarantees that those strategies will work out according to your timetable. What if the market slumps just as you need to sell? What if you can’t qualify to refinance because you don’t have enough equity in your home? These are all possibilities that you need to address before signing on.
A balloon mortgage can allow you to get into a home now, may save you money on monthly payments, and there should be no prepayment penalty for paying it off early. Just be sure you understand the legal and financial responsibility you face if you can’t pay it off according to the terms.