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A mortgage that is payable in full after a period that is shorter than the term. In the 1920s most balloon loans were interest-only the borrower paid interest but no principal. At maturity, usually five or 10 years, the balloon that had to be repaid was equal to the original loan amount. The balloon loans offered today, in contrast, calculate payments on a 30-year amortization schedule, so there is some principal reduction. Assuming a rate of 6.5%, for example, a $100,000 loan would have a balance remaining at the end of the fifth year of $93,611. Comparing a Balloon Mortgage to an ARM: It is useful to compare five and seven-year balloons with ARM's that have the same initial rate periods. Both offer a rate in the early years below that available on a fixed-rate mortgage, and both carry a risk of higher rates later on. But there are some important differences.
Favoring the Balloon: Balloon loans are much simpler to understand and therefore easier to shop for. The interest rate on a five-year or seven-year balloon is typically lower than that on a 5/1 or 7/1 ARM.Favoring the ARM: The risk of a substantial rate increase after five or seven years is greater on the balloon. The balloon must be refinanced at the prevailing market rate, whereas a rate increase on most five- and seven-year ARM's is limited by rate caps. Borrowers with five- or seven-year balloons incur refinancing costs at term, whereas borrowers with 5/1 or 7/1 ARM's don't unless they elect to refinance. Borrowers who are having payment problems may find it difficult to refinance balloons. The balloon contract allows lenders to decline to refinance if the borrower has missed a single payment in the prior year. This is not a problem with ARM's, which need not be refinance. Borrowers may find it difficult to refinance balloons if interest rates have spiked. The balloon contract allows lenders to decline to refinance if current market rates are more than 5% higher than the rate on the balloon.