How balloon mortgages work

When you get close to the end of a loan's lifespan, one option is to take out a lump sum to pay off the entire debt. Your savings will take a hit in the short term, but you can quickly replenish it with earnings that would have otherwise gone toward the monthly payments. And you can finally consider that loan to be satisfied after several years of dedicated payments.

A borrower might prefer to pay off the loan more gradually, so the lump sum payment is only an option. For a balloon mortgage, however, this hefty final payment is required.

Balloon mortgages are typically used for transactions where a borrower does not intend to hold onto the property for a long period of time. Karen Lawson, writing for SFGate, says the mortgage rates and payments are still calculated based on a longer term, such as the 30-year or 15-year mortgage. This allows the borrower to benefit from lower rates and payments for the initial period of the mortgage.

However, these benefits only last for a period of time stipulated by the lender. The financial site Bankrate says this period can be as short as three years or as long as a decade. Once you get to the end of this period, the entire outstanding sum of the mortgage is due in a single payment.

Tim Plaehn, also writing for SFGate, says balloon mortgages are typically used for commercial and investment properties rather than residential properties. The average homeowner would not be prepared to pay off the balance of a 30-year mortgage after a short period of time, but an investor with a balloon mortgage would plan to sell the property before the final payment is due. This way, they can realize the benefits of the lower rate, sell the property before too long a period of time has passed, and be able to pay off the balance of the balloon mortgage while keeping the extra profits.

Of course, such a strategy comes with a significant amount of risk. Plaehn says a borrower needs to be confident enough that they'll be able to sell the property or otherwise be prepared to meet any costs.

The Consumer Financial Protection Bureau says borrowers should consider how they'll be able to make the final payment if necessary, or if they'll even be able to do so. If you're unable to refinance the mortgage or sell the property before the final payment is due, you may be unable to satisfy the mortgage if you haven't planned on how to do so.

The financial site Investopedia says balloon payments are particularly risky when property values are falling. The payments you make before the final payment will be largely dedicated to interest, meaning you won't build up much equity. If you can't make a profit when it comes time to pay off the mortgage, it might be necessary to attempt to continue the mortgage.

In addition, your situation can easily change during the course of the mortgage. You might lose your job or otherwise be faced with financial difficulties, making it harder for you to make the final payment or get approval for refinancing. You might also decide that you'd like to keep the property for longer than you originally anticipated.

Lawson says that if you do not think you'll be able to make the final payment, you can plan to refinance the mortgage several months before the payment is due. This will allow you to get a refinanced mortgage that will pay off the sum you owe.

You can ask the lender if it is possible to convert the balloon mortgage to a 15-year or 30-year mortgage. It might be possible to get a reduction in your rate if the prevailing rate is lower than the balloon mortgage rate, and you might also be able to get a home equity loan or line of credit if you have paid off enough of the mortgage's principal.

Investopedia says it is possible to modify the mortgage as long as your financial situation remains stable. Regular monthly payments, a strong credit score, and a healthy income will all work in your favor.

Balloon mortgages are available for both fixed rate and adjustable rate mortgages but cannot be applied to some payment options, including most forms of qualified mortgages. The Consumer Financial Protection Bureau says balloon mortgages should be considered carefully and that you should consider other types of loans if you do not have a sound plan to meet the loan's obligations.

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