Balloon mortgages have some tempting qualities. They come with lower interest rates and, because of this, smaller monthly payments. This can help borrowers get into a pricier home that they might not have been able to afford otherwise but balloon mortgages come with one huge risk: At the end of a set period, borrowers must pay off the remaining balance on these loans in full (the “balloon”) and these balances can be quite large. So, how exactly do these mortgages work, and who do they work best for? Let’s break it down.
The comments above & below are edited ([ ]) and abridged (…) excerpts from the original article written by Dan Rafter (WiseBread.com)
How balloon mortgages work
A balloon mortgage comes with two parts. First, there’s the standard repayment portion of the mortgage. For a set period of time, usually five to seven years, homeowners make monthly payments just like they would with a standard 30-year or 15-year fixed-rate mortgage.
During this period, homeowners’ interest rates remain the same. This is a positive because the interest rates on a balloon mortgage tend to be lower than on standard fixed-rate loans or adjustable-rate mortgages.
After this period ends, though, the second part kicks in: You’ll have to pay the balance of what you owe (the balloon payment). So if, for example, you still owe $130,000 on your mortgage at the end of your five- or seven-year period, you’ll have to pay that entire $130,000.
Obviously, that’s a lot of money. But most people who take out a balloon loan never make that payment out of their own pocket. Instead, they typically plan to refinance or sell their home before the balloon payment comes due.
If they sell the home, they can use the proceeds to pay off the loan in full. The same thing happens in a refinance: Once the refinance closes, borrowers pay off the remainder of the balloon and settle into making monthly payments on their new loan.
Sadly, unforeseen problems can ruin this plan.
What if, during the five or seven years after taking out a balloon loan, your FICO credit score falls? Now, lenders might not approve you for a refinance. The same could happen if your monthly income drops after taking out a balloon mortgage. Lenders might worry that you no longer make enough money to afford your monthly payments, and they won’t approve you for a mortgage loan.
Then there’s the question of home value. If the value of your home drops after you take out a balloon mortgage, you’ll again struggle to refinance. Most lenders require that you have at least 20 percent equity in your home before they’ll approve your request to refinance. If your home’s value has fallen, odds are you won’t have the equity you need.
Even if you are approved for a refinance, consider that interest rates can rise between the start and end of your balloon loan. If they rise significantly, you could be stuck with a much higher monthly mortgage payment.
If you can’t refinance, you’ll face some dismal options, assuming you can’t afford the balloon payment on your own. The main option would be selling your home. That may not be an issue if you were planning on selling anyway, but what if you weren’t? And what if you can’t find a buyer? If your home has fallen in value since you took out your balloon loan, you might be forced to sell your residence for less than what you owe on your mortgage. If that happens, you still won’t have enough money to pay off the balloon.
If you can’t make that balloon payment, either from your savings, refinancing, or selling, your lender can begin foreclosure proceedings. You could end up losing your home and watching your FICO credit score fall by 150 points or more.
What should you do if you can’t pay the balloon?
If you can’t afford that balloon payment and you can’t refinance or sell, your best bet is to call your mortgage lender immediately. They might be willing to work with you. Maybe your lender will shift your balloon loan to an adjustable-rate or fixed-rate loan, or even extend the term of your balloon loan, giving you more years to either sell, qualify for a refinance, or save up enough to make the payment.
Is it ever a good idea to take out a balloon mortgage?
Given the risks, the short answer is: Maybe.
If you absolutely know that you will sell your home before that balloon payment comes due, this kind of mortgage can work. You’ll get the benefit of homeownership at a lower interest rate and lower monthly mortgage payment. The lower payments might even give you the opportunity to live in a home that you otherwise wouldn’t have been able to afford. Then, you can sell, pay off the balloon, and move on.
It’s difficult to call a balloon mortgage worthwhile otherwise. There are positives to this type of home loan, but they can easily be outweighed by the risks.
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