What Makes It A Balloon?
Picture a balloon in the process of being inflated. The section connected to the air tank (or your lips) is stretched out long and straight, and rather thin. At the far end, however, it’s substantially larger – big and round and potentially ready to burst at some point. That’s the shape of a balloon loan. Or, if you prefer a more technical description, traditional loans like your 5-year fixed rate truck loan or a 30-year adjustable rate mortgage are “fully amortizing.” You pay a combination of interest and principal until your balance is zero. A balloon payment mortgage doesn’t fully amortize. The balance comes due before your monthly payments naturally reduce it to zero.
Balloon mortgages allow the borrower to make small, sometimes minimal payments for a brief period at the start of the loan (two to five years is typical, although much longer loans are sometimes utilized for special circumstances). After that initial period, however, the full balance of the loan is due – hence the “balloon” imagery used to describe these sorts of loans. Early payments may be comparable to what they’d be for a twenty- or thirty-year loan, or possibly lower. Other times they’re set up so the borrower only pays towards the interest until the balloon payment comes due. In some circumstances, borrowers pay nothing at all for the first several years.
A balloon payment mortgage is relatively high-risk for both the lender and the borrower, and not recommended for most normal circumstances. It’s a specialized financial structure intended for a few specific situations and not ideal for the average home buyer even if they’re technically able to qualify. Interest rates can be steep because of the higher risk to the lender, and borrowers who are for any reason unable to make the required balloon payment may find themselves in serious difficulty. Other times, borrowers are able to secure lower-than-average interest rates, especially if the lender shares the borrower’s confidence in their ability to pay off the loan when the balloon comes due.
In short, the details of balloon loans can vary widely depending on specific circumstances – fixed rates vs. adjustable rates, the size of initial payments, and the length of the actual loan are just a few of the most common elements subject to negotiation. Because they are a specialized sort of mortgage, they are often tailored to fit the individual’s situation.
Prior to the mortgage crisis of 2007, it was not unusual for buyers to utilize balloon mortgages as a way to increase profits from essentially flipping their homes every few years. The idea was to buy low, finance at low-interest and making low-initial payments, then sell the property for a profit within a few years. They’d be able to pay off the initial loan and have money left to move on to the next one. This approach to balloon mortgages is far less common now and intensely discouraged.