What is a balloon mortgage & how do balloon payments work?

Balloon loans provide an alternative to standard mortgages and can be useful to homebuyers in some circumstances, but they aren't right for everyone. These home loans get their name from the balloon payment that's due when they mature. Balloon mortgages haven't been widely available since the financial crisis and are not considered qualified mortgages, but you may occasionally still see them advertised. 

What is a balloon payment?

A balloon payment is an extra-large payment on a loan. It's usually at least twice as big as your average monthly payment, and it can be even larger. In some cases, the balloon payment equals the entire principal of the loan.

What is a balloon payment mortgage?

A balloon payment mortgage is any mortgage that requires a balloon payment. This can includes interest only mortgages. 

A balloon mortgage usually has a short loan length of five to 10 years compared to traditional 30-year fixed year mortgages. Payments are typically small, and they might cover only interest or interest plus a little bit of principal. At the end of the loan term, the borrower has to make the balloon payment, which pays off the remaining balance on the loan all at once.

Most home loans are gradually paid off according to a schedule of payments that are split between interest and principal, with the mix between the two shifting over time so that a larger share of each payment goes to principal. This is called an amortization schedule, and a loan that's completely paid off in this way — so that there's a zero balance when the loan term comes to an end — is fully amortizing. 

A balloon mortgage does not fully amortize because at the end of the loan term, the borrower still owes a large balloon payment. Payments on a balloon mortgage are often calculated with an amortization schedule that's longer than the length of the loan. For example, a balloon payment mortgage might have a term of 10 years, but the payments could be set based on the schedule for a 30-year fixed-rate loan.

That means the monthly payments on a balloon mortgage are smaller than what you'd pay on a fully amortizing loan with a similar length, because the payments are calculated based on the assumption that you have a lot more time to pay the loan back. 

What kind of mortgage typically has a balloon payment?

A balloon mortgage is a "non-traditional" home loan that is riskier than standard conventional mortgages. Lenders increasingly issued them in the years leading up to the housing crisis of 2008. 

Following the crisis, regulators took steps to prevent risky loans from jeopardizing the housing market again. Passage of the Dodd-Frank Act led to the establishment of qualified mortgages. 

A lender who issues a home loan that meets the requirements for a qualified mortgage gains some legal protections, and consumers are also protected by this category. Before borrowers can be approved for a qualified mortgage, lenders must look into their finances and make sure they are likely to be able to repay the loan.

Qualified mortgages generally aren't permitted to have balloon payments, except those issued by small companies lending in underserved areas.

Fannie Mae and Freddie Mac aren't permitted to buy balloon mortgages from lenders, so a balloon mortgage is a non-conforming loan.

Learn about other types of mortgages.

Predatory loans

Unfortunately, balloon mortgages appeal to shady lenders. Lenders who want to take advantage of people can emphasize the low monthly payments and gloss over any details about the lump sum payment due at the end of the loan. 

If you're shopping for a balloon loan, you want to be careful to work with a reputable lender that provides complete information about loans you're considering.

Related: Watch out for these mortgage scams

Benefits of a balloon mortgage

As with any type of loan, you want to weigh the pros and cons carefully before deciding whether to apply for a balloon mortgage.

A balloon mortgage offers these advantages:

• Monthly payments are low. That can free up money to save, invest, or spend on something other than housing.
• The short loan term could be just right if you plan to move or refinance soon. If you're not going to stick with this mortgage to the end, the lump sum payment due at maturity might not make much difference to you. You could benefit from the low payments, then sell the home or refinance to a new mortgage well in advance of the balloon payment.
• You can postpone paying the principal for several years. This could be helpful if you're expecting a big jump in income in the future. Maybe you're going to get a bonus at work, or you're anticipating a new job or windfall. In cases like these, a balloon loan allows you to borrow money and buy a home now, make small payments for a time, and then pay off the rest of what you owe down the road.

Disadvantanges of a balloon mortgage

Having a mortgage with a balloon payment waiting for you at the end of the loan term comes with some few significant downsides:

You lose out on building equity

When you make mortgage payments, you're building equity. But if your monthly payments don't cover much of the loan's principal, you aren't making progress toward full ownership of the home. That means the home's value doesn't go on the positive side of your personal balance sheet, and you don't have the option to borrow against it with a home equity loan or line of credit.

Your finances are at risk if you can't make the final payment

For most people, it's easier to repay a debt with regular payments than all at once. And failing to produce enough cash for the payment can have serious consequences. Your lender could foreclose on the home if you aren't able to pay, tanking your credit. Or, you might have to sell your home at a price you're not happy with or refinance with an expensive loan if you can't find better options in time.

It's hard to predict where you'll be financially when the balloon payment comes due. You may have a plan for meeting the balloon payment, such as using the proceeds from an investment or selling other property, but the payment could end up being unaffordable if that plan falls through.

Learn what happens if your mortgage becomes unaffordable.

Application requirements may be strict

Since lenders can't sell a balloon payment mortgage to Fannie Mae or Freddie Mac and the lender protections that go with qualified mortgages don't apply to balloon loans, they don't view this type of home loan as a particularly safe bet. They'll probably expect to see a great credit score and high income and assets before they'll consider issuing a balloon mortgage to you.

Balloon loans aren't widely available. They make up a small share of all mortgages, and many lenders don't offer them.

Should you get a balloon payment mortgage?

Getting a balloon payment mortgage could make sense for you if you're in a great place financially, so that you are likely to qualify for this type of mortgage and you can confidently take on the risk of a non-traditional home loan.

If you're going to choose a balloon mortgage over a standard, safer mortgage, you should have a good reason for that choice. This type of mortgage may make sense if you're certain you won't stay in the home for the full loan term, or if you know you have a big bonus coming that will cover your balloon payment.

You should also have a sound back-up plan in case your original idea about how you're going to make the balloon payment doesn't work out. For example, if you're counting on a bonus from work and that doesn't materialize, you might need to be prepared to refinance the mortgage or sell your home.

There are several potentially valid reasons to take out a balloon mortgage, but keep in mind that this type of loan entails significant risk. If you aren't 100% sure that you can make a balloon payment, it's probably best to go with your gut and choose a standard fixed-rate or adjustable-rate mortgage instead.