Balloon Loans
With a traditional, amortized loan, you will pay the balance of the loan down progressively over the entire life of the loan. At the beginning of the loan, your interest payments will be higher and over time, as the amount of the loan decreases, the interest payments decrease as well. A balloon loan is a bit different. With this type of loan, you will pay lower monthly payments at the beginning of the loan and you will have one large payoff, known as a “balloon payment” at the end of the loan. A balloon loan is typically ranging from five to seven years, which is much shorter than a traditional loan.
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Pros of a Balloon Loan
The benefit of a balloon loan is that you will have lower payments (both principal and interest) for most of the life of the loan. You might also qualify for a lower interest rate than you would with a traditional loan; since a balloon loan is shorter than a traditional loan, lenders might see it as less of a risk. Additionally, this type of loan often allows you to forgo a down payment up front, since there will be a large payment at the end of the loan. A balloon loan is an appealing choice for a homebuyer who doesn’t have a lot of money for a down payment, wants a smaller monthly payment on a shorter loan, and is confident they will be able to afford the balloon payment at the end of the loan.
Cons of a Balloon Loan
The greatest risk with a balloon loan is if the borrower is unable to come up with the money for the balloon payment at the end of the loan. Taking on a balloon loan requires foresight and advanced planning and failing to make the balloon payment could result in a foreclosure. Some borrowers will look at refinancing a balloon loan and converting it to a traditional loan before the final payment is due, but this is not always an option, so it is important to be confident that you will be able to afford the balloon payment once it is due.
Balloon Loans and the Qualified Mortgage rule
A balloon loan is not always an option for a homebuyer. In 2014, the Qualified Mortgage rule was created to make sure that new homebuyers are set up with a mortgage that they can afford. Qualified Mortgage regulations prohibit a lender from selling a risky loan to a buyer, and in most cases, a balloon loan is considered a risk.