Definition
This is a short-term mortgage option that acts like a traditional mortgage for at least several years and then ends, requiring a single full repayment of the remaining balance.
Quick Summary
The "balloon" part of a balloon mortgage refers to how it rapidly expands at the end, quickly coming to a close. Balloon mortgages typically last no longer than 5 to 10 years at the most. For that period, they act (and amortize) exactly like traditional 30-year fixed rate mortgages. You make monthly payments including interest, and there are no surprises. But at the end of the period, the loan ends and you must pay off the entire remaining balance immediately. The solution to this is typically a refinance, or selling the property to help make the payment.
Pros and Cons
Pros-Well-suited if you plan on refinancing or moving. Because these loans only last for a few years, they can be a reasonable choice if you are planning on moving away or getting a refinance during that period. If market conditions improve, you may be able to save money by choosing a balloon mortgage now and refinancing or selling in the future.
-Tend to have lower overall repayment than fixed-rate mortgages. Balloon mortgages tend to have lower interest rates than conventional mortgages. Part of the reason for this is reduced risk – the lender only has to count on several years of payments, instead of 20 to 30 years.
Cons-Require careful preparation. If you want a balloon mortgage to work, you have to be ready to make the full repayment, which means keeping careful control over your finances and timing your refinance or home sale very accurately.
-High risk depending on market conditions. It's a very risk bet to assume that market conditions will be more favorable in 5 to 10 years. They could be worse – which means you may have to pay a lot of cash out of pocket to get rid of the balloon loan. Highly static markets are the safest bet. Also keep in mind that your own personal finances may change in that time, possibly making it more difficult to acquire a refinance.
What Else Should I Know?
With so much risk, you may be wondering why people ever choose balloon mortgages. Well, some borrowers jump into them without knowing what to expect, attracted by the lower-than-usual monthly payments. However, savvy borrowers have a very clear financial plan for the next five or so years, strong control over their credit, and have worked out how much money they can save by using a balloon mortgage now and making other arrangements later. From flipping houses in a robust market to improving credit to get a better refinance, there are places for a well-timed balloon mortgage.