Whether you’re thinking about buying a home or considering investing in real estate, obtaining a mortgage may lead to high monthly payments. With a traditional home mortgage, you finance the purchase price of the property minus your down payment with the addition of interest. If you’re in a tight spot financially, the home loan terms and high monthly payments associated with them may force you to delay your purchase until your earnings increase.
A balloon payment is a financing option that offers a low interest rate and low monthly payments for a certain loan term. During the term, you only pay interest, which equates to low monthly payments. However, once that term is up, you owe the entire loan balance in one lump sum.
While a balloon payment loan helps you make your initial purchase without a sizable financial commitment, there are both benefits and drawbacks to this type of loan. Learn more about how a balloon payment works to determine if this financing option is right for your situation and goals for the future.
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An Explanation of Balloon Payments in Real Estate
Balloon mortgages are associated with shorter loan terms, usually only five to 15 years. In this time frame, the borrower pays small monthly payments because the loan balance doesn’t amortize, or the borrower isn’t actually paying anything towards the loan balance. When this term is up, the borrower owes the rest of the loan balance, usually as one lump sum.
Borrowers may be interested in balloon mortgages if they’re purchasing real estate with the sole purpose of selling it for more than the purchase price a few years later. Borrowers who know they have a lump sum of money coming their way in the near future, such as an inheritance, may also benefit from a balloon mortgage. However, financial literacy and knowing your future financial situation is key before agreeing to this type of loan.
A balloon mortgage allows a borrower to make a purchase and live in the home for a few years with an extremely low monthly payment. When the term is over, the borrower uses the lump sum inheritance to pay off the balance.
Who Is Eligible for a Mortgage Loan With a Balloon Payment?
Most lenders who offer balloon loans deal directly with real estate investors or investment companies. They provide these loans to real estate investors who plan to buy a home, fix it up, and sell it for much more than the original purchase price.
To be eligible for a balloon loan, a borrower must prove their income and discuss with the mortgage broker how they’ll pay the balloon payment when it’s due. To receive good lending terms, the borrower must have an excellent credit score and prove they earn a high income or will in the future.
A balloon loan is financially dangerous for most consumers, unless they have a foolproof plan in place for the end of the loan term when the balloon payment is due. A balloon loan is only a good lending option if the borrower plans to sell the investment and knows its current market value will appreciate. Borrowers who plan to refinance their mortgage and know terms will be better or who are guaranteed to earn a higher income or lump sum later may also benefit from a balloon loan.
Balloon Lease Example
Analyzing an example of how a balloon mortgage works may help you to better understand this borrowing concept. In this balloon mortgage example, a borrower buys a $300,000 home. For the first term of the balloon mortgage, the borrower is responsible for paying the interest and fees for the home, which equates to $2,137 per month.
When this 15-year term is up, the borrower is responsible for the balloon payment. If no additional payments were made throughout the life of the home loan, the entire loan amount is now due in a lump sum, which is $300,000. In most cases, borrowers refinance the loan or sell the home at an appreciated value before the balloon payment is due.
Balloon Mortgages vs. Traditional Mortgages
When choosing between a balloon mortgage and a traditional mortgage, it’s important to analyze your personal budget and goals for your financial future. Keep in mind, a traditional mortgage is associated with higher monthly payments but these payments remain the same throughout the life of the loan. If you opt for a balloon mortgage, your initial monthly mortgage payments are extremely low, but you must be prepared to make the large balloon payment when the term is over.
You should only consider a balloon mortgage if you’re a real estate investor planning to flip a home, you have a large lump sum of money coming within the next few years, or you plan to refinance for better terms before the loan term expires. If you know you’ll maintain a steady income for years to come, a traditional mortgage may be a better fit for you.
Understanding Deceptive Mortgage Lending Practices
Balloon mortgages are often used in advertising campaigns by deceptive lenders to entice borrowers. The low interest rate and small monthly payments are appealing to low-income borrowers who can’t afford to purchase homes. These deceptive mortgage lenders downplay the large balloon payment due at the end of the term so they can trick borrowers into believing they can afford the loan.
Best Practices for Managing a Balloon Mortgage
If you agree to a balloon mortgage, it’s important to plan out your finances for the next few years. While your initial monthly payments are low, you’ll need to prepare your budget for the large balloon payment you’ll owe when the term is over.
Begin saving money each month to eventually cover this payment. Keep an emergency fund ready in case the home needs repairs or you incur other expenses. Even if you plan to sell or refinance before the balloon payment is due, preparing for the worst ensures you won’t default on the loan if things don’t go as planned.
When the Balloon Payment Is Due
You generally have three options when the original term is over and your balloon payment is due. If you’ve received your inheritance or a lump sum in some fashion, make the payment in full. Your balloon mortgage is satisfied and your credit score is positively affected by your lower debt-to-income ratio.
You may also refinance the loan into better loan terms. Once refinanced, you’ll need to continue making payments under the new loan terms to the lender or you risk negative effects on your credit score. You can also sell the home before the balloon payment is due, but this only satisfies the mortgage if you sell it for high enough to cover the loan balance. If you don’t, you still owe the lender until the loan is satisfied.
While a balloon mortgage offers low monthly payments at the beginning, it’s important to be prepared for the lump sum payment you owe at the end of the term. Balloon mortgages are risky and you should only consider them if you have a solid plan to pay off the loan or sell your asset for more than the loan amount.
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