Balloon mortgages aren’t as popular as they were before the financial crisis but they’re still out there, and they offer enough benefits to be considered against other loan types, particularly adjustable-rate mortgages (ARMs). But like ARMs, balloon mortgages also carry a good bit more risk than a 30-year fixed rate mortgage. When is a balloon mortgage the right choice?
How Balloon Mortgages Work
Balloon mortgages are set up very similar to the 30-year fixed rate mortgage. They carry a fixed rate and payment during the entire balloon phase of the loan. For example, they typically come with a balloon phase of 5, 7 and sometimes 10 years. During that timeframe, both your rate and your monthly payment will remain constant.
And although the loan will be due and payable at the end of the balloon phase, your monthly payment is calculated based on a 30-year amortization.
But what makes a balloon mortgage different from a 30-year fixed rate mortgage is the very fact that the loan is due and payable at the end of the balloon term.
At that point, you will likely have to pay off the mortgage, either by refinancing it into a different mortgage or selling the property to satisfy the loan. Some balloon mortgages do have what is known as a “reset” feature. If it does, then rather than you having to pay off the mortgage, the rate on the loan simply resets for the remaining term of the loan, which is up to 30 years.
When the loan rate resets, it will reset based on whatever mortgage rates are at the time that it happens. Even if you take a balloon mortgage that does have a reset feature, you will still have to qualify for the monthly payment – which makes it something similar to doing a refinance. And if it turns out that you don’t qualify for the new payment, perhaps because mortgage rates are substantially higher than when you first took the mortgage, then you will be back to having to pay off the mortgage in some other way.
What this means is that while you can save money on the monthly payment using a balloon mortgage, there is a substantial risk as to what will happen when the balloon term ends. For this reason, you have to be very careful about the circumstances under which you will use a balloon mortgage.
When is a balloon mortgage the right choice?
When a Balloon Mortgage Payment is MUCH Lower than the 30 year Fixed
It may surprise you to learn that the interest rate on balloon mortgages is not always dramatically lower than what it is for the 30-year fixed rate. In fact, the difference in interest rate usually falls somewhere between 0.5% and 1.0%. That means that if a 30-year fixed rate mortgage is currently priced at 4.00%, you might get a seven-year balloon mortgage with a rate of 3.50%.
If you’re going to take a balloon mortgage, it’s important that the amount of money you save on the monthly payment will be considerable.
For example, if you could get a $200,000, 30 year fixed rate mortgage at 4.00%, the monthly payment would be $955. But if the rate on the same loan size were 3.50% for a seven-year balloon, your monthly payment would be $898.
This represents a monthly savings of $57, or $684 per year. This will save you about $4,788 over the seven-year term of the balloon mortgage.
You will then have to seriously evaluate if that savings is sufficient to justify the added risk that comes with a balloon mortgage.
But that’s certainly not the only factor.
When You Expect to Sell the House Before the Balloon Comes Due
Even though the savings on a balloon mortgage may be fairly modest, it may still be worth taking the loan if you have a high expectation that you will sell the house before the balloon comes due.
This can happen if you are living in a location with a high likelihood that it will be a temporary move only. For example, that could be the case if you are early in your career, and have taken a job in a location that you expect to be transferred from in a few years.
It can also be the situation if you are in a career that has a high degree of upward mobility. For example, if you are early in your career, and earning $75,000 per year, but you reasonably expect to be earning $150,000 in five years, a balloon mortgage may be worth considering.
After all, a pay increase of that nature will almost certainly motivate you to purchase a higher-priced home as your income increases.
When You Expect Interest Rates Will Continue to be Low Forever
If you are confident that mortgage rates will stay as low as they are now – or go even lower – for the foreseeable future, you may have a greater comfort level in taking a balloon mortgage. After all, if interest rates are roughly where they are now by the time your balloon mortgage comes due, you shouldn’t have any trouble refinancing the loan.
However, as no one can foresee the future, that can be a dangerous assumption. True, mortgage rates have been low and very well behaved for the past several years. But there’s no denying that they have been substantially below their historic average.
Conversely, if you believe that mortgage rates will be higher in 5 to 7 years, you would necessarily want to stay away from a balloon mortgage, even if it offers substantial monthly savings.
When You Expect to Have the Mortgage Paid Off Before the Balloon Comes Due
Maybe there is an event in the not-too-distant future that will result in you coming into a substantial financial windfall. That could be an inheritance, the payout of a trust fund, or the exercising of stock options. Whatever the source, if it is reasonably predictable, and it will be enough to pay off your mortgage, that will support taking a balloon mortgage.
The idea is that you will get the benefit of the lower monthly payment that the balloon mortgage provides, but there is a high likelihood that you will be able to pay the mortgage off completely before the balloon term expires. If that’s the case, then you don’t have to be concerned with the uncertainty of whether you’ll be able to afford to refinance the loan, qualify for the reset, or to sell the property.
The basic idea to always keep in mind with balloon mortgages is that they are higher risk loans than 30-year fixed rate mortgages. For this reason, you should consider a balloon mortgage only if there are outside factors that will make it more than likely that you can deal with the sudden pay off or refinance of the loan at the end of the balloon term.