Does it pay to get a balloon mortgage?

Balloon mortgage: what is it, and why would you want one?

With talk in the air about higher mortgage rates for 2018, there has been a growing interest in the balloon mortgage, a home loan product that’s very different from the way properties are usually financed.

Freddie Mac says the typical loan is now paid off after just 6.1 years, and that raises an interesting idea: Since lenders don’t like fixed-rate long-term loans – they worry that they’ll be stuck with low returns – maybe they would prefer to finance with a shorter term, say seven years or 10 years. And they’d be willing to charge a lower mortgage rate in exchange for this risk reduction.

How a balloon mortgage works

A balloon mortgage is pretty much like a typical mortgage except for the end of the story. Suppose you can get a $200,000 mortgage at 4.25 percent over 30 years. The monthly payment for principal and interest is $983.88. At the end of the loan term, you owe nothing to the lender.

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With a balloon mortgage, the rate might be 4 percent. For a $200,000 loan, the monthly cost for principal and interest will be $954.83. In our example, you save $29.05 a month or $384.60 a year.

Here’s the catch. The balloon mortgage might only last seven years or 10 years. After seven years, a borrower in our example will owe $172,119. After 10 years, the unpaid balance will be $157,568.

How do you pay off a balloon mortgage?

There are several ways to repay a balloon mortgage. For instance, with the seven-year financing option you might:

First, save up and repay the debt when the balloon mortgage comes due.

Second, make larger payments every month to assure the debt will be completely repaid. For example, to repay in seven years at 4 percent you will need a monthly payment of $2,733.76.

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Third, after a few years, refinance your balloon mortgage with a fully-amortizing one. Be sure to start the process early, in case there are delays when refinancing.

Fourth, sell the property within seven years and repay the loan.

Balloon mortgage worries

When you obtain a balloon mortgage, the terms are very clear. The lender wants its money back. If you do not repay the full amount when due, the lender can foreclose and sell your house at auction.

There are some plain concerns that must be considered before obtaining a balloon mortgage.

First, what happens if the value of your home declines? In that case, a plan to pay off the balloon mortgage through a sale can be in trouble. There is no guarantee that home values will rise. According to the National Association of Realtors, in the third quarter, home values rose in 162 metro areas. At the same time 15 metro areas saw declines.

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Second, what if your income goes down, and you can’t make big monthly payments? The economy is changing. Counting on future income, bonuses, stock options or inheritances is risky.

Third, if you want to refinance, you will again need to qualify with a lender. What if your credit score falls or your income drops? You may not qualify for enough financing to pay off the debt, or the rate and payment may be higher than you want.

Finding a balloon mortgage lender

Not all lenders originate balloon mortgages. One reason is that virtually all home loans today are “qualified mortgages” or QMs. QMs are loans that must meet stringent government affordability standards.

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QMs are hugely popular with lenders because they significantly limit their liabilities. One of the most basic QM standards is that the mortgage must have substantially equal payments for the life of the loan. This means a QM generally cannot have a balloon payment. It also means borrowers will likely have to shop around for a balloon mortgage lender.

Is a balloon mortgage worth it?

Balloon notes plainly represent more risk than 30-year financing. If you get a long-term mortgage, and your income goes down or your credit score falls, the mortgage lender doesn’t care — as long as you make your monthly payment.

With a 30-year mortgage, you don’t have to re-qualify, refinance, or sell the property. And there are 30-year adjustable rate mortgage (ARM) loans with rates fixed for three. five, seven or ten years. These may have rates at least as good as those of the balloon product, with less risk to the borrower.

What are today’s mortgage rates?

Current mortgage rates have risen in recent weeks, and most industry experts believe that they are trending upward over the long-term.

While you may not want to risk a balloon mortgage to save money, you can take a risk-free alternative — simply shopping for quotes from multiple competing mortgage lenders. Studies show that rates typically vary among mortgage lenders by .25 to .5 percent on any given day. You only know if you’re at the “good” end of the range if you do some comparison shopping.