A balloon mortgage is a loan that is not fully amortizing but instead demands full payment of the balance due on maturity.
The maturity is shorter than the term of mortgage.
Because of the large lump sum final payment requirement at the end of the loan, it is thus called a balloon payment. Not because the loans are issued by clowns.
In practice, these loans are generally unsecured and come with high interest rates.
They are mostly used for (but not limited to) short term commercial activity like construction projects and working capital.
This is also partly because businesses find high interest rates as a calculated risk as they can generate an income to cover those costs once their projects are completed. So they are more receptive to it.
While uncommon, they can sometimes be offered to residential projects as well.
Similar to traditional mortgages, a balloon mortgage can have fixed or adjustable interest rates. And sometimes even a hybrid of the two.
In the early years when balloon loans were first introduced to the masses, they tend to be interest-only loans where borrowers only pay interest during the term. At maturity, the borrower will then have to make a full principal repayment which is equal to the original loan amount.
This is no longer the case these days.
An example of a modern balloon mortgage is one that has a monthly payment based on a 30 year amortization schedule. But at the end of 8 years, the balance plus interest owing is required to be paid off in full.
As adjustable rate mortgage (ARM) come with low rates during the initial years of the loan, it bears certain similarities with a balloon mortgage.
This is why they are often compared with each other.
An ARM with an initial 7 years of low rates for example would be a good comparison against a balloon loan that matures in 7 years.
But as you are going to see, they are very different in very big ways.
Differences between balloon mortgage and ARM
The most obvious difference between the two is that a balloon loan is much more easier to understand for a consumer.
And by this, I am not referring to the name of these loans.
You basically work out a repayment schedule over 30 years, make monthly payments for 7 years as in the previous example, and repay the outstanding balance at the end of that in full.
For ARMs, a borrower has to comprehend constant changes to interest rate that either make sense or don’t. The amortization can be rather confusing. And even the adjustable interval can be challenging for some people to understand.
And because of the nature of balloon structured credit facilities, the interest rates tend to be more attractive that ARMs as well.
However, the advantages of balloons just about stops there. Because ARMs have a lot of positives going for it.
Advantages of ARMs over balloons
One of the advantages is that at the maturity of a balloon, should a borrower decide to refinance the outstanding with a new loan, the borrower would be subject to the prevailing market rates at that moment in time.
Contrast that with an ARM at the end of teaser rate years whereby the interest rate will be capped by a ceiling even though index rates might have risen considerably.
This can be a huge difference-maker if interest rates spike.
Secondly, should a borrower go with the refinancing route, he is going to incur the costs associated with refinancing.
This can mean appraisal fees, administrative charges, legals fees, etc, and clowning around all over again.
There are no such fees if a borrower is on an adjustable rate loan unless he opts to refinance it too.
Refinancing would only make sense if interest rates are lower at that point in time, but ridiculous if interest rates are higher. That is without adding on the closing costs.
On this subject, lenders are known to outright decline refinancing a balloon mortgage if the current market interest rates are considerably higher than the rate of the balloon.
The absence of refinancing also means that there is no need for the borrower to go through a round of credit assessment or being judged by an automated underwriting system all over again.
For a 7 year balloon for example, many events could have happened during the 7 years that affected the personal income and credit of the borrower.
If the borrower now has a much lower income or bad credit, he might have a problem getting a lender to approve a refinancing package.
ARMs, without needing to be refinanced, don’t have this problem.
Recast and reset
As lenders slowly learned that many borrowers of balloon loans are unable to fully repay it at maturity, many have introduced the option to “reset” the loan by recasting it with a fully amortizing repayment schedule.
This is sort of triggering the action of a recast clause without needing it to be present.
And because this is more like a privilege offered by the lender instead of an entitlement of the borrower, the lender might impose strict terms and requirements in qualifying borrowers.
Some criteria that a lender might require include:
- No late payments in the repayment history of the balloon
- Credit score that meets a certain standard
- Prevailing market interest rates or higher
- Absence of other liens on the property
In view of all these challenges with a balloon mortgage, it begs the question why someone would chose it instead of an ARM.
The underlying reason is a lower and more attractive interest rates, especially when it is described in APR.
But if the differences are not that considerable compared to an ARM, it’s probably worth signing up for the ARM instead in exchange for the peace of mind and avoid the hassle that a balloon might bring in future.