At some point, everyone who’s interested in financing real estate has asked themselves the question, “What is a balloon payment on a mortgage?” While most balloon payments are no longer allowed to be part of most qualified mortgages for consumer purposes, it’s important to note that they can still be used in non-traditional financing arrangements and investment purposes, like owner financing. Since 2014 the so-called Dodd Frank law prohibits investors for non-seller-occupant deals to include a balloon in the mortgage note.
However, before entering into any loan agreement that includes a larger-than-normal payment, it’s crucial that you make sure you understand how this type of payment works, as well as the advantages and risks that come along with it. Keep reading to learn what you need to know before signing on the dotted line.
What is a balloon loan?
At its core, the term “balloon loan” refers to any loan that requires a lump-sum payment. Sometimes auto loans or personal loans will come in the form of a balloon payment loan. However, in real estate, it’s most common to talk about a balloon mortgage, where the larger-than-normal housing payment usually comes at the end of the loan.
As mentioned above, these days, it’s most common to see balloon mortgages utilized in non-traditional financing and investment-only scenarios. These mortgages can often be found in owner financing arrangements because the lump-sum payment gives the seller the opportunity to receive payment sooner. In addition, it is not uncommon to see balloon mortgages in commercial real estate contexts, especially when a construction loan is involved.
How does a balloon payment mortgage work?
Now that you have a better idea of a balloon mortgage definition, it’s time to take a closer look at how these loans work. With that in mind, we’ve broken it down for you as follows:
Interest-only balloon mortgage
The first type of balloon mortgage is an interest-only mortgage. As the name suggests, in this case, the borrower will only make payments on the interest that accrues on the loan. Then, at the end of the life of the loan, they will be responsible for paying off the entirety of the principal loan balance.
Principal and interest balloon mortgage
In contrast, some balloon payment mortgages allow the borrower to make payments toward both the interest that accrues on the loan and the principal loan amount. Notably, however, the monthly payments will still be lower than they would be if the loan was allowed to fully amortize like a traditional mortgage. Here, at the end of the loan term, the borrower will only be responsible for paying off the remaining loan balance rather than the entire principal amount.
Balloon payment example
For the purposes of this example, let’s say that an interested buyer wants to buy your $300,000 home at an interest rate of 3.0% using owner financing. The mortgage note specifies that the buyer will make a 10% down payment and monthly payments on both the principal and interest for a 10-year period, at which point the balloon payment will come due.
Using those figures, for the first ten years of the loan, you can expect to receive a monthly mortgage payment to be $1,138.34 from the buyer. Then, at the end of the 10-year-period when the balloon payment is due, you will be given a final payment of $206,390.62, which takes care of the remaining loan balance.
What are the pros and cons of a balloon mortgage?
Given the structure that’s outlined above, it should be clear that there are distinct advantages and disadvantages to working with a balloon payment mortgage. We’ve outlined them below for your consideration.
- They allow for flexible financing terms: Since balloon financing is only allowed in non-qualified mortgages, there are fewer guidelines that need to be met. In this case, a balloon payment can be used on both short-term and long-term loans, as well as either a fixed-rate mortgage or adjustable-rate mortgage. You have the flexibility to decide upon the loan terms with the borrower.
- Balloon mortgage rates are typically higher: Typically, if you allow the borrower to only make interest payments on the loan, you can compensate for the lower monthly payment by charging a higher interest rate.
- You’ll receive payment sooner: Often, people will shy away from owner financing scenarios because they don’t want to have to act like a bank for the next 30 years. Adding a balloon payment to a mortgage note allows you to cut down on the amount of time before your loan is repaid in full.
- You can sell a balloon note: If you don’t want to have to wait until a balloon payment comes due to receive your lump sum payment, it is possible to sell a real estate note with a balloon payment.
- They come with more repayment risk: Of course, there is always the possibility that your borrower will not be able to make the balloon payment when it comes due. That’s why it’s especially important to vet any potential borrower if you’re considering this type of loan.
Should I consider a balloon loan?
At the end of the day, though balloon loans aren’t commonplace anymore, they can be used in certain financial situations. Particularly as a seller, balloon payments can be an advantageous feature to include in a home loan. However, like any financial arrangement, this type of loan does come with its own advantages and disadvantages, so you’ll want to be sure to do your research before signing any legally-binding documents.