Balloon mortgages involve the payment of a lump sum to clear the outstanding mortgage loan after a specific period of time. A common form of balloon loan in the auto industry is to borrow a certain sum to purchase a car, and agree to a balloon payment at the end of the loan period.

For example you could borrow $8,000, amortize just $5,000 of this over 3 years and pay the other $3,000 as a lump sum (balloon) at end of the 3 years. This reduces your monthly principal repayment, though not your interest – you still pay interest on the $3,000 over the full term of the loan. Such loans are useful if you intend selling the vehicle at that time for the $3,000 or expect a lump, such as an investment maturing, when the balloon is due for payment.

Balloon Loans and Mortgages

With mortgages, balloons are commonly paid after a set period such as 5 – 7 years. Your mortgage is amortized over the normal 15 or 30 years. However, after an agreed period, the outstanding principal is paid as a lump sum. The lump sum can come from an investment, by refinancing the property, or from the proceeds of selling the real estate.

In other words, if you wish to retain ownership of the property, a balloon mortgage is somewhat similar to an adjustable rate mortgage (ARM.) In fact, many people prefer them to adjustable rates mortgages. So what advantages does a 7-year balloon mortgage offer of a normal 7-year ARM?

Balloon Mortgages versus Adjustable Rate Mortgages

Let’s assume that you are comparing a 7-year adjustable rate mortgage and a 7-year balloon. You make your monthly payments based on a 15 or 30 year repayment period. At the end of 7 years, the balance of the principal still due on your 7-year balloon loan must be paid in full.

Generally you will do that by refinancing your mortgage. With the 7-year ARM, you would renegotiate your mortgage rate. Very similar in appearance, but not quite the same. So what’s the difference?

Advantages of an ARM

Some people choose an adjustable rate mortgage to protect against future rate rises. The interest rate of an ARM would likely rise by less than that of a refinance. That is because there is generally a maximum rate attached to an adjustable rate mortgage, but not on the refinance when the full interest rates at the time would apply.

Another advantage of the ARM is that the balloon, involving refinance, will be subject to refinancing costs. The ARM will not since it is not a refinance. Another aspect of the ARM that arises because it does not involve financing is that it doesn’t matter if your credit or FICO score has plummeted in the intervening period.

Mortgage refinance to pay a balloon would be subject to a higher interest rate, or even refused completely if your FICO score has dropped much below 600. You would then likely face foreclosure if you cannot raise the cash for the balloon. In fact, some lenders will refuse to refinance a mortgage loan if any payments have been missed during the previous year.

Advantages of Balloon Mortgages

If you have been repaying your mortgage on time for the seven years, a balloon mortgage is easy to refinance. Once the period is up and the balloon becomes payable, refinancing is organized at the current mortgage rate at that time. Setting up and implementing an ARM is more complex, particularly when the seven years are over and the rate is reset.

Additionally, the mortgage rate of a balloon mortgage is lower during the initial seven year period than that of an ARM, because adjustable rate mortgage rates are capped. That means a higher rate is generally applied at the beginning to compensate for this. Balloon mortgages are therefore more affordable in the early years when new buyers might be earning less.

Which is better: ARM or Balloon Loan?

Balloon mortgages carry more risk because any inability to refinance if you are unable to pay the balloon payment, may cause you to lose your home. The one situation where the balloon mortgage wins over an ARM is if you intend selling up after the initial period and paying the balloon with part of the proceeds.