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What Is A Balloon Mortgage And How Does It Work?

10-minute read

November 11, 2021

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If you’re looking to buy a home, you’re probably considering various mortgage options for home financing. There are conventional loans, loans from the government and other non-conforming loans. There are also various options for term length and fixed or adjustable rates.

One option you might run across is a balloon mortgage. This type of loan 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 option that includes a lump sum payment that could be scheduled 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 borrowers make monthly interest payments and pay the entire balance at the end of the loan. Then there are loans with principal 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. Unlike traditional loans, balloon loans don’t fully pay off through regular monthly payments. Borrowers have to be prepared to pay off the remaining loan balance at the end of the loan term. Rather than being left to the end of the term, a lump-sum payment could also happen in the middle. There are a few ways to handle this, and we’ll get into those later on.

What Would My Payment Schedule Look Like?

There are a couple of different ways your balloon mortgage 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.

Interest-Only Balloon Schedule

Month Interest

Balance

1 $531.25 $150,000.00
2 $531.25 $150,000.00
3 $531.25 $150,000.00
4 $531.25 $150,000.00
5 $531.25 $150,000.00
6 $531.25 $150,000.00
7 $531.25 $150,000.00
8 $531.25 $150,000.00
9 $531.25 $150,000.00
10 $531.25 $150,000.00
11 $531.25 $150,000.00
12 $531.25 $150,000.00
109 $531.25 $150,000.00
110 $531.25 $150,000.00
111 $531.25 $150,000.00
112 $531.25 $150,000.00
113 $531.25 $150,000.00
114 $531.25 $150,000.00
115 $531.25 $150,000.00
116 $531.25 $150,000.00
117 $531.25 $150,000.00
118 $531.25 $150,000.00
119 $531.25 $150,000.00
120 $531.25 $150,000.00

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 mortgage setup, 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.

Balloon Schedule With Principal Payments

Month Payment Interest Principal Balance
$300,000.00
1 $2,028.57 $1,062.50 $966.07 $299,033.93
2 $2,028.57 $1,059.08 $969.49 $298,064.44
3 $2,028.57 $1,055.64 $972.92 $297,091.52
4 $2,028.57 $1,052.20 $976.37 $296,115.15
5 $2,028.57 $1,048.74 $979.83 $295,135.33
6 $2,028.57 $1,045.27 $983.30 $294,152.03
7 $2,028.57 $1,041.79 $986.78 $293,165.25
8 $2,028.57 $1,038.29 $990.27 $292,174.98
9 $2,028.57 $1,034.79 $993.78 $291,181.20
10 $2,028.57 $1,031.27 $997.30 $290,183.90
11 $2,028.57 $1,027.73 $1,000.83 $289,183.07
12 $2,028.57 $1,024.19 $1,004.38 $288,178.69
183 $2,028.57 $190.12 $1,838.45 $51,841.83
184 $2,028.57 $183.61 $1,844.96 $49,996.87
185 $2,028.57 $177.07 $1,851.49 $48,145.38
186 $2,028.57 $170.51 $1,858.05 $46,287.32
187 $2,028.57 $163.93 $1,864.63 $44,422.69
188 $2,028.57 $157.33 $1,871.24 $42,551.45
189 $2,028.57 $150.70 $1,877.86 $40,673.59
190 $2,028.57 $144.05 $1,884.51 $38,789.08
191 $2,028.57 $137.38 $1,891.19 $36,897.89
192 $2,028.57 $130.68 $1,897.89 $35,000.00

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.

Note 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. 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 as 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 types of home loans is that balloon loans have a lump sum payment at some point during the loan. Other loans fully pay off at the end of the loan without any lump-sum payments. This is accomplished through amortization, which refers to the way 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 toward 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.

30-Year Fixed-Rate Mortgage Schedule

Month Payment Interest Principal Balance
$200,000.00
1 $708.33 $275.55 $199,724.45
2 $983.88 $707.36 $276.52 $199,447.93
3 $983.88 $706.38 $277.50 $199,170.43
4 $983.88 $705.40 $278.48 $198,891.95
5 $983.88 $704.41 $279.47 $198,612.47
6 $983.88 $703.42 $280.46 $198,322.01 
7 $983.88 $702.43 $281.45 $198,050.56
8 $983.88 $701.43 $282.45 $197,768.11
9 $983.88 $700.43 $283.45 $197,484.66
10 $983.88 $699.42 $284.45 $197,200.20
11 $983.88 $698.42 $285.46 $196,914.74
12 $983.88 $697.41 $286.47 $196,628.27
349 $983.88 $40.87 $943.01 $10,596.18
350 $983.88 $37.53 $946.35 $9,649.83
351 $983.88 $34.18 $949.70 $8,700.13
352 $983.88 $30.81 $953.07 $7,747.06
353 $983.88 $27.44 $956.44 $6,790.62
354 $983.88 $24.05 $959.83 $5,830.79
355 $983.88 $20.65 $963.23 $4,867.56
356 $983.88 $17.24 $966.64 $3,900.92
357 $983.88 $13.82 $970.06 $2,930.85
358 $983.88 $10.38 $973.50 $1,957.35
359 $983.88 $6.93 $976.95 $980.41
360 $983.88 $3.47 $980.41 $0.00

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.

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Calculating A Balloon Mortgage Payment

Now that you have an understanding of what a balloon mortgage is and how it works, use this balloon mortgage calculator to compute your monthly payment and total balloon payment.

Let’s start with a simple scenario in which you’re not paying off any of the principal, but making interest-only payments in full and pay off the loan with a balloon payment at the end of the term.

In this case, you’ll need to know the amount of the loan and the interest rate. So let’s say you have a $300,000 loan at 4% interest annually.

Because this is an annual rate, the first thing you need to do is divide it by 12 to get to a monthly payment. After that, it’s multiplied by the loan balance. So the formula is as follows:

MP=B*(I/12)

MP is the monthly payment. B is the loan balance and I is the annual interest rate. When you plug the numbers in, you get a $1,000 monthly payment.

If you have a monthly payment for your balloon mortgage in which your loan partially pays off, but doesn’t fully pay off, the easiest way to calculate your monthly mortgage payment is to know your starting loan balance and the balloon payment at the end of your term. In this case, we’ll also have to know the length of the term.

The first thing to do is to subtract the balloon payment from the starting loan balance. From there, you can calculate the payment as you make any standard amortizing mortgage payment.

Let’s say you have the same $300,000 loan with a 4% interest rate. This type at least partially amortizes so that by the time you get to the end of your 30-year loan, you’ll have a $35,000 balloon payment left.

The easy part of this is subtracting the balance at the end from the beginning balance. This leaves you with $265,000 which amortizes over the life of the loan.

We’ll also need to know the monthly interest rate so you can divide 4% by 12. You also need to know the total number of payments being made. That’s 360 on a 30-year loan.

Once we have those two figures, we plug them into the following formula:

MP=AB*i*(1+i)

______________________

(1+i)n-1

AB is the portion of the balance that amortizes. i is the monthly interest rate. n is the number of monthly payments over the long-term. This is brutally hard to type in your calculator, so if you have access to Excel, I recommend using the PMT function. It’s going to ask for present value, which is the amortizing balance of $265,000; the monthly interest rate, which is 0.0033%; and the number of periods, or 360 monthly payments. When you put that into the formula, you get a monthly payment of $1,259.05.

When Is A Balloon Mortgage A Good Idea?

In general, for most people, balloon mortgages are not a good idea. Still, if you’re considering it, this section will discuss the pros and cons.

The Pros

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 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. You don’t pay off the full balance of the balloon loan until the lump sum at the end.

  • Avoid large payments for several years: If you have a lot of furniture expenses or home renovations that need to be done, a balloon mortgage grants you a much lower mortgage payment for several years.

  • Afford a home faster: If you don’t want to rent and have a down payment for a house, a balloon mortgage can be a viable option. It allows you to buy a home while also having a cheaper monthly mortgage payment, which could help you save or use money for other expenses.

  • Get finances in order: A balloon mortgage may be a practical option if you’re working on building credit or savings and boosting your income to qualify for a future loan.

  • Short-term mortgage: If you don’t plan on living in your house long-term, you can sell your property before the balloon payment is due. Of course, this presumes home values keep rising. On the other hand, a lot of these mortgages are short-term. You can avoid making mortgage payments in the long term if you pay off your mortgage with the balloon payment at the end of the loan period.

The Cons

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 options are necessarily guaranteed, and sometimes life gets in the way. There’s a higher risk that the loan goes south because of the huge payment at the end.

  • Higher risk for lenders: When you take out a mortgage, your home becomes collateral. If you fail to make loan payments or pay the lump sum at the end of the term, your lender may have no option but to foreclose your property. Foreclosure incurs a number of costs for lenders and is a process they want to avoid whenever possible.

  • 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. 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. 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 difficult to 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. Refinancing often requires a minimum amount of equity. If you don’t have 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 the 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.

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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 save up and make the balloon payment. This may make the most sense if you want to get into a house now and 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 they stay in the job, they 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 flipping the property, it’s easier to get a home loan like a balloon mortgage because you typically have to occupy or hold the property for a length of time before selling it.

Refinancing

The other way balloon payments are typically paid off in the mortgage space is by refinancing into a traditional mortgage. In order to do that, there are several elements to consider.

When you refinance, 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 amortizes by the end of the term, it’s important to note that your payment will almost certainly increase.

Refinancing would be a good choice if you have enough equity or can pay the closing costs to do the refinance while staying in the home with no plans of moving in the near future.

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 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 on you having your credit and income together along with 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, it makes sense to get a balloon mortgage if you can pay off the back part of the loan and want to invest your money in other areas for the time being.

The remainder of this section will go over why you might have trouble finding a balloon mortgage and alternatives that accomplish some of the same goals.

Finding A Lender

Many lenders, including Rocket Mortgage®, 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. 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 capping 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.

The Bottom Line

Before settling on a mortgage, it’s important to understand your financial situation to help decide which loan is best for you. We have several mortgage calculators you can take a look at to assist with this process. Additionally, check out our guide to help determine how much you can afford when buying a house. 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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Rocket Mortgage® lets you get to house hunting sooner.

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