Balloon Mortgages

by Tanya Davis

Borrowers who are shopping around for mortgages are often mystified by balloons. A balloon mortgage is a combination loan; it is easiest to think of it as having a fixed-rate portion and an adjustable rate mortgage portion. It is called a "balloon mortgage" because it doesn't fully amortize over the life of the loan -- the borrower is left with a lump sum payment at the end of term. That's the balloon.

In the beginning a balloon loan works just like a fixed-rate mortgage. The payments are calculated the same way they would be if the borrower just carried a regular fixed rate mortgage. The principal and interest payments can be figured by using an amortization schedule or mortgage calculator.

The interest rate on such a loan might be tempting because it is quite low. But after the initial loan term, the terms change; the outstanding balance on the loan has to be repaid in full. This means that the principal has to be paid as a lump sum. Usually, it requires that the home owner refinance. More often than not, because the initial payments didn't lower much of the principal, payments will increase.

The initial fixed-rate portion of a balloon mortgage is anywhere from one to 10 years, with the most common length of time being five to seven years. More recently, the trend has become to offer a package that includes two loans: one mortgage for 80% of the loan, and the other 20% is a 15/30 balloon mortgage. This is a "piggyback" arrangement, done in order to avoid PMI (Private mortgage insurance). These are fairly safe for most borrowers, especially if a rather long term is selected for the initial portion of the loan. That's because most people only stay in their homes from five to seven years, making them able to sell before they have to pick up the 15/30 balloon payment.

Some lenders offer a conversion option at the end of the fixed-rate term. For example, it may convert to a 30 year mortgage at market plus one half of one percent. There may be a processing fee required in order to convert the loan. A conversion option gives the borrower an opportunity to make provisions for the second half of the mortgage, but will still allow him to refinance in a different way if there is a better choice. Sometimes the loan is set up from the beginning as a two-step mortgage, which means that at the end of the fixed-rate term mortgage will convert to an agreed-upon loan at current market rates. The new loan may be an ARM or a fixed rate mortgage.

Balloon mortgages can be good for temporary use, for example, when one partner has taken time off from work to raise the children or go back to school. They're also good for people who do know that they will have a larger income in a few years, due to graduation, inheritance, or paying off a large debt. However, most lenders do not feel that balloon mortgages allow borrowers to build much equity in the home. It is also possible that the principal becomes due, the market or the borrower's financial situation has changed, making it difficult to refinance the loan. For this reason, balloon mortgages are most often sought out by commercial investors rather than people purchasing a private residence.