Definition of "Balloon Mortgage"
Mortgages typically amortize over time through fixed value installment payments. However, there's a type of mortgage that doesn't: the Balloon Mortgage.
It's called this way because, with it, the borrower sets a time period where he'll pay fixed value installments and, after that, he is obligated to pay the remaining balance of the loan at once. So, as you can visualize, the name balloon mortgage comes both from the shape of the balloon, going from narrow to wide - just like the payments - as well as the act of popping the balloon with one spike/payment.
Balloon Mortgage history:
In the 1920’s most balloon loans were interest-only; the borrower paid interest but no principal. When it reached maturity - usually 5 to 10 years - the “balloon” that had to be repaid was equal to the original loan amount. It was a risky situation, usually endured when the borrower had confidence his/her financial capacity was going to improve in the near future.
The Balloon Loans offered today, in contrast, calculate payments on a 30-year amortization schedule, so there is some principal reduction.
Comparing a Balloon Mortgage to an Adjustable Rate Mortgage (ARM):
It is useful to compare five and seven-year balloon mortgages with adjustable rate mortgages that have the same initial rate periods. They are similar in offering a rate in the early years below that available on a Fixed Rate Mortgage, and both carry a risk of higher rates later on. However, there are some important differences.
- Favoring the Adjustable Rate Mortgage: The risk of a substantial rate increase after 5 or 7 years is higher with the balloon mortgage. The balloon must be refinanced at the prevailing market rate, whereas a rate increase is limited by rate caps on most 5 and 7-year adjustable rate mortgages. Borrowers with 5 or 7-year balloons incur refinancing costs at term, whereas borrowers with 5/1 or 7/1 adjustable rate mortgages don't - unless they elect to refinance. Also, borrowers who are having payment problems may find it difficult to refinance balloons contracts, as they allow lenders to decline to refinance if the borrower has missed a single payment in the prior year. This is not a problem with adjustable rate mortgages, which need not be refinanced. Borrowers may find it difficult to refinance balloons mortgages 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 loans.
- Favoring the Balloon Mortgage: Balloon loans are much simpler to understand and therefore easier to shop for. The interest rate on five-year or seven-year balloon loans is typically lower than that of a 5/1 or 7/1 adjustable rate mortgage.
Real estate advice:
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