What Is A Balloon Mortgage?
A balloon mortgage is a loan in which most or all of the principal is repaid on a predetermined date. While balloon mortgages are seldom found in conventional loans, they are common in commercial and rental home loans.
Related: Buying a house? Make sure you’re prepared by reading our complete guide on how to buy a home.
The loan is commonly amortized for 20 or 30 years, meaning payments are structured based on a loan term of this length. However, after a set time period (usually 2 to 5 years), the loan is due in full and the borrower owes the remaining principal balance. If the balance is not paid in full, the lender will foreclose upon the property.
Construction companies often use this type of financing (also called a construction loan), as it provides short-term financing for projects without the need for collateral. This allows them to build within the time frame they’ve scheduled with their client. However, these loans are often unsecured and come with high interest rates.
Balloon Mortgages Vs Conventional Loans
Compared to the typical 30 year mortgage, a balloon mortgage can look very attractive. For example, banks offered a 5/1 ARM which offered a “teaser rate” much lower than a conventional 30 year mortgage. This was often offered in the form of a 5 year interest-only loan, and these mortgages were issued to sub-prime (aka risky) borrowers.
The problem was that while the borrow could afford to pay the interest on the loan, after 5 years their rates reset to the market and many loans had balloons on them. This meant that in order to pay the principal of the 5/1 ARM, they had to refinance the home.
Rates had increased and they were either unable to qualify or couldn’t afford the principal on their new loans (remember, the ARM only required them to pay interest, not principal).
You are probably asking why banks issued these loans. The answer is simple – they sold them by the end of that day. Then investment banks like Goldman Sachs packaged them up and sold them to third parties like pension funds and insurance companies. And what happened? The 2008 financial crisis that still haunts many investors.
Do banks still issue Balloon Mortgages?
Yes, many banks still issue balloon mortgages, and there is a place for them in today’s economy. However, borrowers typically need to have strong balance sheets and personally guarantee the loans. Additionally, balloons are now more common in commercial loans than with conventional mortgages.
As many investors are aware, property held in the name of an LLC does not typically qualify for a conventional mortgage. For this reason, many rentals are bought with balloon loans. However, their loan-to-value ratios are usually lower and are tenant occupied, which means eventually rental increases should offset rising interest rates, making them more stable.
Are there any risks?
As with any investing decision, you must consider every possible outcome. Many home buyers may have a plan to refinance the mortgage traditionally. But there are some things they should remember during the buying process.
- There is no guarantee that you will qualify for to refinance down the road. You could lose your job and have no income, your credit score could plummet, or your business may not grow as planned.
- Interest rates may rise at the end of your loan term, resulting in higher monthly payments after refinancing.
- If your property value falls, the bank may loan you less than the property is worth. This is what we call “being underwater” on your mortgage.
Should You Get A Balloon Mortgage?
If you are a commercial property investor, a balloon loan may be your only option, and is commonly utilized. However, if you are a homeowner seeking financing for your personal residence, we highly suggest sticking to the tried-and-true conventional 30 year mortgage.
