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What is a balloon mortgage, and when should you get one?

Yahoo Personal Finance· Getty Images
6 min read

The term “balloon mortgage” may sound lighthearted, but it actually refers to a relatively complicated type of home loan. This is a lesser-known type of mortgage loan characterized by lower initial monthly payments followed by a larger final payment, often called the "balloon payment." Despite its playful name, a balloon mortgage can be risky and even lead to foreclosure if you’re not careful.

While some borrowers should steer clear of balloon mortgages, they can be worthwhile options for others.

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A balloon mortgage is a short-term loan that doesn’t fully amortize over its term like a traditional mortgage. In this context, amortization refers to the rate at which the mortgage principal is paid down on a loan.

With a full amortized loan, you would make monthly payments, and by the final payment, the mortgage balance would be completely paid off. In a partially amortized loan like a balloon mortgage, though, only a part of the sum must be returned in monthly payments. In other words, with a balloon mortgage, you’ll only make small payments for a defined period to pay off a fraction of the loan balance. Then, the rest will all be due at the end of the term with one lump sum payment. This lump sum payment is the “balloon” part of a balloon mortgage.

Balloon mortgages come with varying terms and maturities and may be adjustable- or fixed-rate mortgages. But unlike traditional mortgages that have 15-year or 30-year terms, balloon mortgages typically have much shorter loan terms of just five to seven years. Depending on how the balloon mortgage is structured, the initial payments may go only toward mortgage interest or to both interest and the loan principal.

These are the three common types of balloon mortgages:

With a balloon payment mortgage, you’ll make lower monthly payments based on an extended amortization period. At loan maturity, typically after five or seven years, you’d make a single balloon payment to pay off the remaining loan balance.

An interest-only mortgage means you’ll only need to make monthly payments on the interest your loan is accruing. You’ll then pay off the entire principal balance at the end of the term.

With this balloon mortgage type, you don’t have to make any payments during the initial term, typically five or seven years. However, at the end of the loan term, you must pay back the interest and entire principal balance in a single balloon payment.

Balloon mortgages are not for everyone. Take a look at these pros and cons to help you decide whether a balloon mortgage is right for you.

  • Shorter loan terms. Compared to traditional mortgages, which typically have terms of 10 to 30 years, balloon mortgages’ shorter loan terms of five or seven years allow you to pay off the mortgage more quickly.

  • Low monthly payments. Since balloon mortgages are partially amortized, you can expect to make relatively low initial monthly payments before paying a lump sum at the end of the loan term.

  • More flexibility. Balloon mortgages allow you to take advantage of the lower initial payments without committing to a long-term loan, which gives you more flexibility in managing your finances.

  • Takes longer to build equity. If you’re only paying interest (or a very small amount of your principal) on your balloon mortgage, you won’t be able to build much home equity during the loan term.

  • There’s more risk you’ll default and lose your home. The most significant risk and downside of a balloon mortgage is that you could face foreclosure if you can’t make the balloon payment at the end of the term. A foreclosure could seriously damage your creditworthiness and overall personal finances.

  • Higher interest rates. Because balloon mortgages are risky, many lenders charge higher rates than a regular mortgage. Each lender is different, though.

  • Hard to find a mortgage lender. Because balloon mortgages are risky, not many mortgage lenders offer them. You’ll have to shop around to find a company to give you this type of loan.

Ready to start looking at balloon mortgages? Read our reviews of lenders that offer at least one type of balloon loan:

  • Pay the remaining balance in full. The most straightforward way to pay off a balloon mortgage is to pay the remaining balance in one lump sum at the end of the loan term. Make sure to save money throughout the loan term so you have enough to cover this one-time amount.

  • Refinance. Another option is refinancing the balloon mortgage to another mortgage type before the lump sum payment is due. However, this strategy only works if you have a decent credit score and have built up equity in the home — and remember, a balloon mortgage’s structure makes it difficult to build home equity.

  • Sell the home. You can also sell the home and use the proceeds to pay off the balloon mortgage. Just know that there’s a possibility that you may not be able to sell the property at a high enough price to cover the remaining loan balance.

Balloon loans offer flexibility but are also very risky. These mortgage types can make sense if you already have the full payment saved up, expect to eventually sell the home, or plan on refinancing the mortgage during the loan period.

However, if none of the above applies to you and you have a low risk tolerance level, consider safer mortgage alternatives such as conventional, FHA, USDA, and VA loans first. Talk to a mortgage broker or financial adviser if you’re unsure which option is best for your situation.

If you can't make the balloon payment, your lender can foreclose on your home, which could seriously damage your credit and hurt your ability to get a new mortgage in the future. Foreclosures show up on your credit report for seven years.

A five-year balloon mortgage means it has a loan life of five years. However, your lender may calculate your fixed monthly payments as if you had a 30-year loan. This means the loan will not fully amortize over those five years, and a large payment will be due at maturity to cover the remaining loan balance.

According to the National Association of Realtors?, balloon mortgages are best for experienced homeowners, real estate investors, commercial developers, and short-term home buyers who plan to move or flip the property within the mortgage term.

This article was edited by Laura Grace Tarpley.