Definition
A balloon mortgage is a type of home loan that features low monthly payments for a set period, followed by a large lump-sum payment (the “balloon payment”) at the end of the loan term. This type of mortgage is typically short-term (5 to 7 years) and is often used in real estate investment or by borrowers who expect to sell or refinance before the balloon payment comes due.
Explanation
Unlike a traditional fully amortizing mortgage, where the loan is gradually paid off over 15 or 30 years, a balloon mortgage keeps monthly payments low by covering only interest or a small portion of the principal. When the loan term ends, the borrower must either pay off the remaining balance in full, refinance, or sell the property.
Balloon mortgages are considered risky because they require the borrower to either have a large sum of money available at the end of the term or the ability to refinance under favorable conditions. If housing market conditions change, property values drop, or interest rates rise, refinancing may become difficult or expensive.
This type of mortgage is commonly used by real estate investors who plan to flip a home before the balloon payment is due or by homeowners who expect to receive a financial windfall before the loan term ends.
Example
A homebuyer takes out a $250,000 balloon mortgage with a 5-year term and an interest rate of 4%. Their monthly payments are calculated as if the loan were on a 30-year schedule, meaning they only pay a small portion of the principal.
- For the first five years, they make low monthly payments of around $1,193, covering mostly interest.
- At the end of year 5, they still owe a balloon payment of $225,000 in one lump sum.
At this point, they must pay off the remaining balance, refinance the loan, or sell the property to cover the cost.