What Is a Balloon Payment and How Does It Work?

Housing costs are on the rise and it may be difficult for many people to afford the monthly mortgage payment that goes along with owning a home. However, there are options out there that make homeownership more accessible. One option that you may want to consider is a balloon mortgage. Read on to learn more about this mortgage concept to determine whether it’s right for you.

What Is a Balloon Payment?

A balloon payment is the large payment that is made at the end of a balloon mortgage. In a balloon mortgage, you do not pay the same amount every month with the end goal of paying off the mortgage at the end of the term. Instead, you pay a lower amount every month before paying a large lump sum to pay off the remaining balance at the end.

How Does a Balloon Payment Work?

There are two different forms of balloon mortgages you should know about. First, there are interest-only mortgages wherein you only make monthly payments on the interest accrued by the loan until paying off the extremely large remaining balance at the end.

Second, there are also balloon mortgages wherein you pay towards both the principal and the interest of your loan on a monthly basis -- albeit at a lower rate than a traditional mortgage. This leaves you with a smaller and more realistic balloon payment at the end of the loan.

Balloon loans can be as long as 30 years or for as short as three years. When choosing your balloon loan term, it may make sense for you to pay more in interest over a long-term loan in exchange for a smaller balloon payment at the end of the term. On the other hand, if you’re confident that you can afford an extremely high balloon payment in a relatively short period of time, you may want to save money on interest and go with a short-term loan.

Pros and Cons of Balloon Payments

As with any type of payment plan, there are both pros and cons of choosing a balloon payment that you should consider before you sign on the dotted line.

Here are some of the pros of balloon payments:

More affordable mortgage payments: Perhaps one of the biggest advantages of a balloon payment is that it makes your monthly mortgage payments more affordable. Instead of paying a higher amount every month, you pay a lower amount and pay the remaining balance in a lump sum at the end of the term.
Save up for other expenses: Since you aren’t spending as much money on your monthly mortgage payment, you’re able to save up more money for other expenses like renovations, furniture, etc.
Get into a home quickly: Balloon payments can make homeownership more accessible for those that have enough money for a down payment but still need to save money on monthly expenses. Instead of saving up or waiting to earn enough income to afford a home with a traditional mortgage, you could use a balloon mortgage now.
Improve your finances: Balloon payments can provide you the financial flexibility you need to tackle problematic areas of your portfolio. For instance, instead of spending thousands of dollars on your mortgage payment every month, you can put that money towards paying off credit card debts, student loans, etc. to improve your credit and qualify for a traditional mortgage.
Ideal for a short-term mortgage: If you’re only planning on being in the home for a few years before selling again, a balloon payment could prove to be quite beneficial. This option would allow you to make low monthly payments but sell the home before the balloon payment is actually due.

Here are some of the cons of balloon payments:

High risk: Balloon payments are high risk for both borrowers and lenders. The borrowers risk not being able to afford the balloon payment at the end of the term. You never know what your financial situation is going to look like years down the line, so being on the hook for such a large payment is definitely a risk. Similarly, lenders risk loan failure in the result that the borrower cannot afford the high amount of the balloon payment. Lenders also will not accrue as much return during the life of the loan, making it less worthwhile for them.
Puts you at the mercy of the market: Many people initially agree to balloon mortgages with the goal of refinancing down the road to avoid the eventual balloon payment. However, this assumes that refinancing will be affordable and worthwhile. Again, it’s impossible to predict the future -- especially when it comes to something as unpredictable as the mortgage and housing markets.
Less favorable rates: Balloon mortgages may come with higher rates than other types of mortgages. Unsurprisingly, this goes back to risk. Since lenders are risking more with this type of loan, they are going to charge you a higher interest rate to mitigate that risk.
Hard to refinance: Not only are you at the mercy of the market when it comes to refinancing your balloon mortgage, but you’re still subject to refinancing requirements that often say that you need to have a certain amount of equity in the home to qualify. Since you’re making such low payments and aren’t really touching the principal loan amount, it may be difficult for you to build enough equity needed to refinance.

Ways to Pay Off a Balloon Mortgage

While paying off a balloon mortgage may sound impossible, there are essentially three ways to do this:

For starters, you could simply save up enough money throughout the lifetime of the loan to afford the balloon payment. Perhaps you’re anticipating a significant increase in income over the next few years and you’re confident that you’d be able to afford it. Or perhaps you’re flipping the home and you’re able to easily cover the balloon payment with the profits you’ve made from the property.
Another way that you can pay off a balloon mortgage is to refinance it into a traditional mortgage before the balloon payment is due. That being said, refinancing isn’t necessarily a straightforward process that everyone qualifies for. You need to make sure that you have a good credit score, debt-to-income ratio, and enough money to pay the closing costs for your new loan.
The last way that you can pay off a balloon mortgage is to sell the home before the balloon payment is due. Of course, this scenario assumes that you’re making a profit on the home rather than a loss and are able to pay off such a high amount. This scenario is ideal for buyers looking for short-term property ownership rather than their forever home.

Alternatives to Balloon Mortgages

Of course, balloon mortgages aren’t the only financing option available when it comes to buying a home. You should always consider all of your options before deciding on the one that best fits your needs.

Here are some alternatives to balloon mortgages:

Traditional mortgages: Also known as conventional mortgages, this is the typical 15 or 30-year fixed-rate mortgage offered by big banks and other lenders.
Adjustable-rate mortgage: Conversely, there are also adjustable-rate mortgages that often start out with low interest rates with the potential to rise due to market forces down the road.
FHA mortgages: These mortgages are backed by the federal government to reduce the risk taken by the lender and make homeownership more accessible to those with lower credit, income, and financial resources.
Hard money loan: While not ideal, a hard money loan can quickly and easily get you the cash you need to buy a home. Since this type of loan comes with high interest rates, it’s best used in the short-term.
Private money loan: If possible, you may want to consider a private money loan from a friend or family member to finance your real estate purchase. Since this is a personal agreement, it is often more flexible, personal, and accessible.

How to Find a Lender That Meets Your Needs

Since balloon mortgages are considered a risky business venture for lenders, not everyone offers them. In fact, you may be hard-pressed to find a lender that’s willing to give you a balloon mortgage. You may need to consider alternative lending sources like online lenders to secure this type of mortgage.

No matter which lender you go with, you need to make sure that they are easy to work with. Look for a lender that prioritizes transparency throughout the entire process as well as communication and customer service. For a lender that meets all these qualifications and then some, check out Vaster Capital.

The Lowdown on Balloon Payments

While a balloon payment may be beneficial for some, it’s still a risky decision for nearly everyone involved. There may be better loan options out there for you that are more secure and less risky. For the best loan advice, feel free to reach out to the lending experts at Vaster Capital for professional advice that is tailored to your unique needs.

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What Is a Balloon Payment and How Does It Work?