Balloon Payment Mortgage – Good or Bad Idea?

If you are asking yourself, “Should I refinance my mortgage or buy property now?” you’re smart to consider all your mortgage alternatives. One alternative most people overlook is a balloon payment mortgage. Most people think about fully amortized mortgages. “Fully amortized” simply means that the monthly payments include both interest and principal. And that means at the end of the period, you have no more mortgage and you own the property free and clear.

Interest-only loans don’t include the principal payments, and as a result the monthly payments are lower. But since you aren’t paying down the principal, you remain in debt after many years of making those payments. That’s where balloon payments come into the picture.

If you select an “interest only” loan, at some point you’ll have a balloon payment to make. This balloon payment means you have to repay the entire principal in full in one shot or refinance. Is this an option for you?

In order to answer this question, you have to ask yourself a few questions:

1. How long will you live in your home?

Generally, balloon payment loans are made for short periods of time. A 10-year balloon payment loan would be hard to find. The more common periods are two to five years. So, for example, if you plan on living in your home for 10 years and your balloon payment comes due in five years, you’re going to have a problem. You’ll have to refinance and incur the high costs of doing so, plus take a chance on paying higher interest rates that prevail at the time. Risky move. On the other hand, if you have a balloon payment due in 10 years and you plan on moving in seven, it’s not a problem. For most people who plan on living in their home for more than 10 years, the best choice is between a 30 and a 15-year mortgage.

2. Are you OK with higher interest rates and costs?

Balloon payment loans expose lenders to more risk. That’s because they don’t get any of their principal back for many years. Those lenders are going to need to be compensated for that added risk. That means you’re going to pay higher interest rates and upfront costs. Understand that and make sure you are OK with that. The only way to really know what extra costs you are paying is to compare your balloon payment to a conventional 30-year fully amortized loan. Even if you can’t qualify or have no intention of applying for such a loan, find out what the rates and costs are for such loans. Then you’ll know if you’re being hosed or not for the balloon payment mortgage.

3. How’s your cash flow?

Most people go with balloon payments because they have no other way to get into the home – they can’t afford the payments of the conventional, fully amortized loans. Realize that this might work out well, but it is a very aggressive move.

When you do this you are locking yourself into a higher cost loan, and one which you’ll certainly have to refinance or move. You’re also betting that interest rates will be stable or lower than they are today. And that’s not all. You’re also betting on real estate appreciating before your balloon payment loan comes due. That’s the bet lots of people made – and lost – over the last five years. It’s why many people lost their homes and had to move in with their obnoxious brother-in-law. Don’t let that happen to you.

Don’t get me wrong. Just because it’s an aggressive move, it doesn’t mean it’s a losing proposition. I just want you to be aware of what you are getting yourself into. If the only reason you are interested in a balloon payment loan is because you can’t afford the home any other way, consider buying a condo or smaller home or renting until you can comfortably afford payments for a fully amortized loan.

Balloon payment loans might be easy for some period, but you’ll have to pay the piper at some point. When you do, it will be expensive and potentially damaging.

What has been your experience with balloon payment loans? Did you ever go this route? How did it work out for you?