Balloon Mortgages - How Do They Work?

To some people just mentioning the words "balloon mortgage" is upsetting. Perhaps they were burned by one in the past, or know someone else who has been. Most people feel that balloon mortgages present a dangerous risk that is to be avoided.

Is it true? Is there any risk involved with a balloon mortgage? Yes, but any mortgage has a certain degree of risk associated with it should you not afford to make the payments. It is true however, that balloon mortgages typically carry more risk than a standard mortgage. It is also true, that they can have their advantages.

How does a balloon mortgage work? Here is an example of a balloon mortgage compared to a standard mortgage that clearly displays the differences.

A standard mortgage comes with a fixed rate, you pay a specified amount each month for the entire fixed term of the loan (usually 30 years). The mortgage interest rate remains the same throughout the term of the loan, or periodically adjusts if an adjustable rate mortgage was chosen.

With either standard mortgage you're looking at thirty years of steady payments.

However, the balloon mortgage offers a much shorter term. You will only have to pay a lesser amount for a shorter period of time. Most balloon mortgages come with a five to seven year term, though it can be as little as three years, or as many as ten.

Unlike the standard mortgage, the entire balance of the loan is not paid over the specified term. Instead, at the end of the term, a large balance remains that must be paid. This balance is what is referred to as the balloon payment.

Why would anyone want to be faced with such a large payment?

Maybe they plan to live in the home for only a short time and will have sold and moved out before the balloon payment comes due. This would allow them to benefit from the lower monthly mortgage payment. Some people expect a large increase in income, or perhaps a large lump sum payment coming their way making them able to pay off the balance due.

Can something be done for someone in this position whose circumstances have changed? Perhaps, you are unable to move, or unable to make the final payment; you could lose the house.

This nightmare example can be avoided by the simple inclusion of a clause in the balloon mortgage contract that allows you to convert the balloon mortgage to a standard mortgage. This is very much like leasing a car, and then buying it at the end of the lease. You make regular lease payments for a few years, and then you decide whether to pay the balance in full, or refinance it into a standard car payment.

There is one factor that you have no control over. Interest rates; should they have risen you could find your payments are suddenly a lot higher then you had hoped.

Overall, and for most people, balloon mortgages are not the best option. But, to some they may be very useful under the right circumstances. Just be certain you are aware of any and all potential risks before putting your name on the dotted line.

Copyright 2007 Carl DiNello