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What is a Balloon Mortgage?
When purchasing a home, many mortgage options are available. One lesser-known option is the balloon mortgage.
A balloon mortgage offers low or no monthly payments initially, followed by a large lump-sum payment at the end of the loan term.
Homebuyers might consider a balloon mortgage for several reasons, such as if they expect a significant income increase or plan to sell the property before the balloon payment is due. However, not all potential homebuyers are eligible for a balloon mortgage.
As a real estate agent, understanding how balloon mortgages work will prove helpful when discussing alternative financing options with your client.
How Does a Balloon Mortgage Work?
The core characteristics of balloon mortgages are their timeline and structure.
Balloon mortgages usually have terms ranging between five and seven years and lower interest rates than traditional fixed-rate mortgages.
During the early years of a balloon mortgage, the borrower makes low monthly payments primarily toward covering the interest. The lender recoups their principal when the borrower pays the remaining balance, the balloon payment.
Balloon mortgages have a slow rate of principal reduction in the initial years. In contrast, a significant portion of the monthly payments of a traditional mortgage go toward covering the principal balance.
Lenders have become more cautious about which borrowers they accept, making obtaining balloon mortgages increasingly challenging.
Let’s break down the three main types of balloon mortgages:
1. Balloon Payment Mortgage
With a standard balloon mortgage, borrowers make lower monthly payments based on an extended amortization period. The remaining balance comes due as a single balloon payment at maturity.
2. Interest-Only Mortgage
Borrowers make even lower monthly payments during the initial term because they are only required to pay interest. The entire principal balance is due at the end of the term.
3. No Payments Balloon Mortgage
Borrowers make no payments during the initial term. While this might be compelling to potential homebuyers with tighter budgets, it poses the highest risk. At the term's end, borrowers repay the interest and principal balance in a single balloon payment. This option is rarely offered today due to its significant risk.
Advantages and Disadvantages of Balloon Mortgages
The needs of every client will vary. Knowing the advantages and disadvantages of balloon mortgages can help real estate agents and homebuyers decide if it's a valuable financial choice. We break them down below.
Advantages of Balloon Mortgages for Homebuyers
Shorter Loan Terms
Balloon mortgages typically range from five to seven years, compared to traditional mortgages lasting 15, 20, or 30 years. Shorter loan terms appeal to homebuyers wishing to quickly pay off the home without incurring additional interest.
Lower Payments for the First Few Years
If homebuyers expect their financial situation to shift significantly during the loan term, they can take advantage of the low initial payments and prepare for the balloon payment.
Typically No Prepayment Penalty
For those who finance with balloon mortgages, there may be flexibility to make additional payments towards the principal without incurring prepayment penalties.
Potential Downsides of Balloon Mortgages for Homebuyers
Risk of Foreclosure if Unable to Make Payments
The most significant risk of a balloon mortgage is foreclosure if the borrower can’t make the balloon payment at the end of the term. Foreclosure can result in the loss of the home, emotional distress, and impact the borrower’s credit negatively, generally for seven years.
Limited Ability to Build Equity
The first balloon mortgage payments primarily cover the interest rather than the principal. Paying the interest rather than the principal means homeowners don't build equity in their homes in the loan's early years.
Harder to Find Lenders
With lenders becoming more selective about balloon mortgage eligibility, borrowers must meet stricter criteria than they would for a traditional mortgage. Borrowers may need a strong credit history, documentation of income, and proof of funds to make the balloon payment.
Difficult to Refinance
A big challenge may be finding another lender willing to refinance the remaining loan balance. Additionally, refinancing may result in higher monthly payments if interest rates rise.
Impact of Balloon Mortgages on Home Affordability
Balloon mortgages can impact home affordability in both positive and negative ways.
The lower initial payments are an affordable way for buyers to acquire a home with a safe strategy to meet the balloon payment. Buyers anticipating an increase in income, perhaps through a raise, inheritance, selling other property, or paying debts, are good candidates for a balloon mortgage.
However, the balloon payment can create financial stress and limit affordability for some homebuyers. If a property with a balloon mortgage forecloses, the borrower faces the loss of the home and, with that, increased difficulty buying another home.
Qualifying for a mortgage after foreclosure is possible, but the foreclosure information remains on a person’s credit report for seven years.
The Role of REALTORS® in Balloon Mortgage Transactions
As a client’s primary source of information, agents who are REALTORS® need to be well-informed on everything balloon mortgages entail. Once the client determines a balloon mortgage fits their financial position, you can steer them to a mortgage broker or lender who can assist them.
Educating Clients about Balloon Mortgages
REALTORS® have the duty of thoroughly educating their clients about the responsibilities attached to balloon mortgages if it’s an option they’re contemplating. Note that balloon mortgages do not qualify as Qualified Residential Mortgage (QRM) loans.
Clients often look to REALTORS® for insight on financing opportunities. If buyers are considering balloon mortgages, it will be valuable to understand qualifications to help guide them in the right direction. The Real Estate Investing Certification by NAR trains REALTORS® to work with investors based on their needs. It can help you understand the pros and cons of different investment opportunities and the mortgages that best fit them. This certification can help you identify clients who may be good candidates for balloon mortgages.
Assessing the Optimal Buyer for a Balloon Mortgage
As a real estate professional you want to help your clients choose the right mortgage. The low initial payments of a balloon mortgage may attract first-time homebuyers or those buying a full-time residence, but these may not be the ideal borrowers for lenders.
The optimal buyers for a balloon mortgage are short-term homebuyers, experienced homeowners, real estate investors, and commercial developers.
Individuals with a home ownership history and a well-established financial track record are usually well-suited for balloon mortgages. These buyers tend to have the financial insight and resources to handle the balloon payment.
Short-term homebuyers and investors who plan to relocate or flip within the balloon mortgage term are also ideal balloon mortgage buyers.
Mitigating Risks and Navigating Potential Issues
Real estate agents play a pivotal role in guiding homebuyers to the right mortgage choice. Understanding various mortgage types, including balloon mortgages, allows you to tailor recommendations to match clients’ financial goals. By educating clients about the risks and benefits of different mortgages, REALTORS® can empower buyers to make informed decisions, mitigating potential pitfalls.