What is a Balloon Mortgage Loan?
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Before the Great Depression, almost all mortgages in the United States were balloon loans. The loans were called balloon mortgages because the loan ended with a much larger payment than all the previous payments. Since the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, traditional balloon mortgages have gone extinct for most homebuyers. But these loans haven’t gone away altogether. Certain loans still have balloon payment features, even though they aren’t called balloon loans. Plus, investors struggling to find financing for a rehab may find a balloon mortgage fits their needs. When should you consider the balloon mortgage?
We explain the pros and cons of balloon mortgages. We’ll also explain loans that have balloon features, even though they aren’t called balloon mortgages.
- What is a balloon mortgage?
- Balloon mortgage pros
- Balloon mortgage cons
- Who’s a good fit for a balloon mortgage?
- What are the alternatives to a balloon mortgage?
- Does a balloon mortgage make sense for you?
What is a balloon mortgage?
Balloon mortgages are mortgage loans where a scheduled payment is more than twice as big as any of the previous payments. For example, before the Great Depression in the United States, most mortgages were five- or seven-year balloon mortgages. Borrowers would make interest-only payments on the mortgage for five to seven years. At the end of the term, the borrowers would pay off the loan in full.
More recently, between 2001 to 2006, a balloon feature was common in subprime mortgage lending. At that point, most borrowers tried to refinance their loans just before the balloon came due. When housing prices tumbled between 2006 and 2009, many borrowers who expected to sell or refinance their homes couldn’t. Ultimately, many borrowers with balloon loans defaulted and had to leave their homes.
Today, lenders can still issue balloon loans, but most don’t. Banks cannot sell balloon loans in a secondary market, so they have to keep these risky loans on their books. Rather than holding onto these “non-qualified mortgages,” most lenders stopped issuing them.
Lenders that do issue balloon mortgages tend to be hard money lenders that specialize in “fix-and-flip” loans for investors. Unless a hard money lender is licensed with the Nationwide Mortgage Licensing System and Registry, they cannot issue consumer loans.
Even if banks were issuing balloon mortgages, Tendayi Kapfidze, chief economist for LendingTree, explained that the loans aren’t likely to be a good fit for most people. “People are more risk-averse than before the crisis and lending standards are stricter,” he said. “I don’t see a lot of use cases for using a balloon mortgage.”
In particular, the five-, seven- and 10-year balloon mortgages that were popular among subprime borrowers before the financial crisis are unlikely to be a good product for most homebuyers. That said, it’s worth considering both the pros and cons of this type of loan (if you can find one). It’s also worth considering the alternatives, mortgages that offer some of the same pay-more-later advantages but fewer risks than balloon loans.
Balloon mortgage pros
Possibly lower interest rates. Interest rates on mortgages are determined by many factors, including the length of the loan. Since balloon loans have short terms (ranging from five to seven years), they could have lower interest rates than comparable 30-year term loans, according to Kapfidze. But this isn’t always the case. For example, hard money loans tend to be high-risk loans, so borrowers will face high interest rates in most cases.
Allows you to buy sooner. Homebuyers expecting a large cash windfall may find that a balloon mortgage fits their needs. Perhaps they expect a large settlement, to sell a business or to receive an inheritance in the next few years. These borrowers may be able to buy their dream home now while they wait for the funds to pay off the loan.
Finance investment rehabs. Investors looking to rehab a house are unlikely to find financing from a bank or another traditional lender. But fix-and-flip loans (which have balloon features) will allow you h2 complete the construction project while making low monthly payments. However, as a borrower, you need to be careful with these loans. They often come with high interest rates and high fees.
Balloon mortgage cons
High risk. When you take out a balloon mortgage, you typically agree to pay off a huge mortgage balance in just a few years. If you can’t make the payment, you’ll be forced into selling your house or defaulting on the mortgage. Unless you’re certain you’ll have the money to pay off the loan, a balloon mortgage is quite risky.
Might not be able to refinance. Before the most recent housing market crash, many subprime borrowers assumed that they would be able to refinance their mortgages before the balloon came due. Unfortunately, many didn’t qualify for a mortgage refinance because of the low values of their homes. When you take out a balloon mortgage, it’s impossible to predict the future. Will you have the necessary income, credit score or home value to refinance your loan in five or more years? Kapfidze cautioned: “When the balloon payment comes due, you need to have the funds to pay it off. Who knows whether you’ll be able to refinance in five to 10 years?”
Investment may not pay off. Although a hard money loan can help investors finance a flip, investors have no guarantee that their investment will pay off. Construction delays, a change in the market or cost overruns could mean that you’re unable to pay off the balloon payment on time or in its entirety.
Who’s a good fit for a balloon mortgage?
In general, buying a house with a balloon mortgage has gone out of favor, and neither lenders nor consumers seem eager to bring the loans back. But there are a few cases where loans with balloon features may make sense. These are a few scenarios when you may want to consider a balloon mortgage.
Building or rehabbing a home. Construction loans are mortgages that help you finance the building or major rehabilitation of a home. Once construction is complete, you typically have to pay off the entire construction loan. Most of the time, borrowers pay off a construction loan by refinancing the loan to a conforming mortgage. Since construction takes 18 months or less in most cases, the balloon payment on a construction loan isn’t considered a huge risk. But borrowers need to be careful to maintain their income and credit scores during construction so that they can qualify for the mortgage when it’s needed.
Aging in place. Reverse mortgages are loans that allow seniors to tap into the equity of their home without making payments on the loan while they live in the house. When reverse mortgage borrowers sell a home or die, the principal value of the loan, as well as interest and fees, must be paid right away. Traditionally, people who inherit a home with a reverse mortgage sell the house to pay off the mortgage.
Moving time. Bridge mortgages are loans with terms of 12 months or less that allow borrowers to buy a new home before selling their existing home. These loans typically need to be paid off in full after six to 12 months. But most people pay off the loan by selling their house.
Flipping a house. Investors who don’t qualify for better renovation loans might be stuck financing a project with a balloon mortgage. These loans may be expensive, and you will be required to make a large payment at the end of the loan. Despite the risks and the costs, this could be a good fit if you’re confident that you’ll walk away from the flip with a profit.
Expecting a windfall. Although traditional balloon mortgages are hard to find, a seven-year balloon mortgage makes sense in a few cases. For example, a family that expects to earn a higher income over time may enjoy the low payments of a balloon mortgage and the ability to buy sooner rather than later. Likewise, someone expecting a windfall could use a balloon mortgage to finance a house, then use the proceeds of the windfall to pay it off. Finally, a person who plans to live in a house a short time before selling or refinancing faces less risk when taking out a balloon mortgage compared with long-term buyers.
What are the alternatives to a balloon mortgage?
Single-closing construction loans. Historically, people who wanted to finance a newly constructed home had to obtain interim construction financing from a bank. But lenders now can issue single-closing construction loans. These loans allow qualified borrowers to close on their construction loan and their long-term financing option at the same time. Closing on both loans at the same time reduces the risk that you won’t qualify for a new mortgage once the builders complete construction.
Adjustable-rate mortgages. Adjustable-rate mortgages (ARMs) typically carry lower interest rates at the start of the loan. But borrowers face the risk that the interest rate and loan payments could increase. Unlike balloon loans, the full balance of an ARM doesn’t come due at once. Instead, the monthly payment could increase by a few hundred dollars based on changes to the interest rate. You can ask your lender to estimate the highest payment you might face under the ARM before deciding if the savings is worth the risk. Despite the risk, ARMs make sense when buyers expect their incomes to increase before the first rate adjustment. With ARMs, homebuyers can typically qualify for a larger mortgage when they first buy a home.
Federal Housing Administration graduated payment mortgages. Under an FHA graduated payment mortgage, homebuyers will see their payment increase over the course of several years. These loans are ideal for people who want to buy a house today but cannot afford the payments on their own. The loan program also has built-in features that make it more likely that a borrower can afford the new payments as they increase.
Conventional mortgage refinance. In the unlikely event that you’re carrying a balloon mortgage, you know that you need to pay off the loan once the balloon comes due. Refinancing to a conventional mortgage is the easiest way to guarantee you won’t lose the house if you can’t afford the final payment.
Does a balloon mortgage make sense for you?
Balloon mortgages are risky for consumers and nearly impossible to find. But mortgages with balloon features such as construction loans, bridge loans and reverse mortgages may make sense for your personal situation. If you’re considering a loan with a balloon feature, be sure you understand the risks and benefits of taking on that loan. Additionally, consider whether you can find less risky alternatives.
Real estate investors who can more readily find balloon mortgages should also carefully consider the risks of the loans. Although a balloon mortgage may offer the most favorable borrowing terms at first, you could be forced into selling a rehabbed house in a down market or on unfavorable terms. Be sure that you can complete and sell the investment property before the balloon payment comes due.