Disclaimer: Rocket Mortgage® does not currently offer 5-year ARMs.
If you’re looking to buy a home, you’re probably considering various mortgage options for home financing. There are conventional loans and loans from the government. There are also various options for term length and fixed or adjustable rates.
One option for you to take a look at might be a balloon mortgage. This option has some upsides and a big downside. We’ll go over balloon mortgages, compare them to other options and then talk about how to decide if one is right for you.
What Is A Balloon Mortgage?
A balloon loan is any financing that includes a lump sum payment schedule at any point in the term. It’s usually at the end of the loan.
Balloon loans come in a few different types: there are interest-only mortgages where you just make the interest payments and the entire balance is due at the end of the loan. Then there are loans where there are balance and interest payments that lead to a smaller lump-sum payment at the end. They can be used for everything from cars and mortgages to personal loans.
In real estate, you can get a balloon mortgage. This works like any other balloon loan with interest-only options as well as types that include both principal and interest. The main thing to know about balloon loans of any kind is that they don’t fully pay off through regular monthly payments. You have to be prepared to deal with the lump sum payment, usually at the end. There are a few ways to handle this, and we’ll get into these later on.
What Would My Payment Schedule Look Like?
If you’re getting a balloon loan, there’s a couple of different ways your payment could work. Let’s take a look at some examples starting with an interest-only loan. Although both of these examples we’ll discuss below are based on fixed interest rates, the interest rate could also adjust based on market rates.
If you have an interest-only loan, you have a standard monthly interest payment that’s smaller than it would be on a loan that pays off at the end of a term. But unless it transitions to a different payment at some point, you’re never paying off any principal. The full balance would be due in a big payment at the end of the term.
In a different balloon loan set up, there are payments to the principal each month, although they are lower than they would be if the loan fully paid off by the end of the term.
If there are payments toward the balance, your mortgage documentation will define the amount of the balloon payment you owe at the end of the term. In the example above, there’s a $35,000 balloon payment at the end of a 17-year term.
One thing to note is that while you should always check your mortgage terms, usually there’s not a prepayment penalty involved in paying your loan down or paying it off early, so you can often make payments toward the principal in order to minimize the impact of a large balloon payment at the end of the loan.
Balloon loans can be as long as 30 years for a term or a short as 3 – 5 years. You might pay more interest on longer-term loans, but a longer term gives you more time to save for the balloon payment if you have to. It just depends on your financial goals.
How Does A Balloon Loan Differ From Other Loans?
The difference between a balloon loan and the other loans you can get is that balloon loans have a lump sum payment at the end of the loan. Other loans fully pay off at the end of the loan. This is accomplished through something called amortization. Amortization simply refers to the way in which a loan is paid off over time.
An amortization schedule will show you how much of your monthly payment goes toward interest and how much goes towards the principal, or the balance of the loan. At the beginning of the term, you pay more toward interest than principal, but that flips the closer you get to the end of the loan. When you reach the end of your term, the loan reaches maturity and pays off.
To give you an idea of what this looks like, let’s take a look at the beginning and end of 30-year fixed-rate mortgages.
You’ll notice that with the loan above, you’re always making payments toward the balance and it fully pays off by the end of the loan. This is the case with all fully amortizing loans, whether they’re fixed or adjustable.
When Is A Balloon Mortgage A Good Idea?
Balloon mortgages can be appropriate choices in certain instances. They also come with a fair amount of downsides. This section will discuss the pros and cons.
The following are among the benefits of a balloon mortgage.
- Lower monthly payments: Whether you have a loan that’s fully interest-only or one that’s partially amortizes with principal payments, your mortgage payment is going to be lower with a balloon loan than it would with a loan that fully pays off because you don’t pay off the full balance until the lump sum at the end.
- Avoid large payments for several years: If you have a lot of expenses for furniture or things need to be done on the house, a balloon mortgage allows you to have a much lower mortgage payment for several years.
- Afford a home faster: If you really don’t want to rent and you have a down payment, a balloon mortgage can be a viable option to allow you to buy a home while also having a cheaper monthly mortgage payment which could allow you to save or use money for other expenses.
- Get finances in order: If you’re a working on your credit or working to build up savings and income for a future loan, a balloon mortgage can be a viable option while building up to qualify for the traditional loan.
- Short-term mortgage: If you know you’re not going to be in the house long, you can sell your house before the balloon payment becomes due in a few years. Of course, this presumes home values keep rising. On the other hand, because a lot of these mortgages are short-term, if you can pay it off with the balloon payment at the end of the term, you can avoid having mortgage payments in the long term.
While there are benefits to balloon mortgages, there are a fair number of drawbacks. Let’s run through them.
- Higher risk for buyers: Because you end up paying a large lump sum at the end of the loan, you either have to have a lot of money saved up over time or you have to be able to refinance. Neither of these things is necessarily guaranteed, and sometimes life gets in the way. There’s a higher risk that the loan goes south because of that huge payment at the end.
- Higher risk for lenders: To begin with, there’s a higher risk that the loan will fail and the house has to be foreclosed on because making that balloon payment is a big outlay for someone. Beyond that, you’re not getting as much steady cash flow because the monthly payments aren’t as high on a balloon loan as they would be on a regular mortgage.
- Potential for market change: Market conditions can have a big impact on the overall affordability of the loan because mortgage rates can move up or down and if property values go down, it can make it harder to refinance, especially if you’re in an interest-only period where you’re not seeing any equity gains.
- Qualified mortgages tend to have better rates: Traditional mortgage investors like Fannie Mae, Freddie Mac, the FHA, VA and USDA have specific guidelines for qualification, including down payment and debt-to-income ratio, but the loans fully amortize so you don’t have to worry about the balloon payment and interest rates tend to be better because there is less risk for the lender.
- May be difficultto refinance: Because you’re certainly building up less equity than you would making a payment on a regular mortgage (if you have any equity at all), it can sometimes be difficult to refinance balloon mortgages. The reason for this is that refinancing often requires a minimum amount of equity. If you don’t have that the existing equity in your home, you’ll have to bring quite a bit of cash to the closing table.
Will My Interest Rates Be Higher Or Lower?
Initially, interest rates on a balloon mortgage may end up being lower than comparable amortizing fixed or adjustable rate mortgages. If you combine that with the fact that you’re paying either interest only or paying on a partially amortizing balance resulting in a lower payment, it sounds like a good deal. On the other hand, there are several ifs to be aware of.
If the interest rate is adjustable and those rates go up, it could make the payment more difficult to afford. Additionally, if property values drop, you could have a harder time refinancing and getting out of those higher interest rates. The interest rate isn’t really a pro or con.
How Can I Pay Off A Balloon Loan?
There are a couple of different ways that balloon payments are commonly made. Let’s take a look at these.
Saving For Your Balloon Payment
The first and most obvious option is to just save up and make the balloon payment. This may make the most sense if you want to get into a house now, but you’re anticipating a significant rise in income in the near future. Not a lot of people can know for a fact that their income is going to rise, but it’s possible. Members of unions often have seniority stipulations in their contract so that as you stay in the job, you can expect a certain pay increase. While others may plan for a yearly raise, there are no guarantees.
The other situation in which you might pay off a balloon loan in cash would be if you were selling the home because you managed to improve and flip the house. If you’re doing property flipping, it’s easier to get something like a balloon mortgage than a standard home loan because you typically have to occupy or hold the property for a length of time before selling it.
The other way balloon payments are typically paid off in the mortgage space is to refinance into a traditional mortgage. In order to do that, there are several things to consider.
Understand what you’re getting into. When you refinance, you need to understand that you’re paying off one loan by taking on another under different terms. If you’re going from an interest-only loan payment to one that fully amortize is by the end of the term, it’s important to note that your payment will also almost certainly increase.
Refinancing would be a good choice if you have enough equity or can pay the closing costs to do the refinance and you plan on staying in the home with no plans of moving in the near future. If you have the money to pay the balloon loan off and move forward without any mortgage payment at all, that’s another option. But many people would have to deplete their savings if they had the money to do that at all.
Of course, in order to refinance, you have to be able to qualify. Part of qualifying for a mortgage is making sure you have a good enough credit score. You can qualify for an FHA mortgage with a median FICO® Score of 580 or better. It’s important to note that you can qualify with higher DTI ratio and formal loan options with a median FICO® Score of 620 or higher.
There are also income and asset considerations to make. You need to make enough income in order to qualify for the home loan. As a general rule, you want to make sure that your monthly debt payments don’t exceed more than 43% of your monthly income in order to qualify for most possible options. It’s also recommended that you have at least 2 months’ worth of mortgage payments available as reserves in the event of a loss of income, although every mortgage program has different requirements in terms of assets.
The main risk of relying on this approach is that you may not be able to do it. Refinancing relies not only on you having your credit and income together along with having sufficient assets. But there may also be factors beyond your control, like current property values in your area and its effect on the amount of equity you have that can impede your ability to qualify. You should certainly speak with a Home Loan Expert about your options.
Should I Get A Balloon Mortgage?
A balloon mortgage is certainly a viable financing option for some, but because of the massive backend payment, it's a tough pill to swallow financially. In general, one of the only times it makes sense to get a balloon mortgage is if you could already pay off the back part of the loan and are getting a mortgage because you want to invest your money in other things for now.
The remainder of this section will go over why you might have trouble finding a balloon mortgage and also alternatives that accomplish some of the same goals.
Finding A Lender
Many lenders, including Quicken Loans®, don’t offer balloon mortgages. The primary reason for this is that there’s a ton of risk involved in tying a large principal payment to the very end of the loan. That’s a lot of money to assume people have lying around. For that reason, your options when shopping around for a balloon loan will likely be limited. With that said, there are common alternatives that might help you accomplish some of the same goals.
Alternative Mortgage Structures
If you’re getting a balloon mortgage, one common reason for doing so is to save money on your mortgage payment. One alternative you could take a look at is an adjustable rate mortgage.
Standard adjustable rate mortgages commonly have 30-year terms, but for a period at the beginning of the loan – usually 5, 7 or 10 years – your interest rate is lower than what you can get on comparable fixed-rate mortgages. If you haven’t sold your home by the end of the teaser period, you can either refinance into a fixed-rate mortgage or let your ARM adjust based on current market interest rates. The level of increase is subject to capped to prevent sudden payment shock. Once the interest rate is adjusted, your loan is reamortized over the remainder of the term. ARMs usually adjust once or twice per year until the loan is paid off.
Another alternative is to take something like a 30-year fixed loan. Although the level of interest you pay will be higher, you’ll be paying less on a monthly basis due to the longer term.
Before settling on any loan option, it’s important to understand your financial situation to help decide which loan is best for you. We have some mortgage calculators you can take a look at. Also check out this guidance on determining how much you can afford. If you have any doubts, feel free to consult a financial advisor.
Now that you understand balloon mortgages and the alternatives, if you’re ready to get started, you can apply online with Rocket Mortgage®.
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