The largest investment most people make in their lifetime is buying a house. Beyond the obvious items like finding a house that you like in a good neighborhood, you will want to find a mortgage loan that is appropriate for you. A balloon payment mortgage is one choice that prospective homeowners can take into account. While it may have certain benefits, there are also dangers to take into account. We’ll discuss balloon payments in this post, including what they are, how they work, pros and cons, and more.
1. What is a balloon payment?
A balloon payment is a substantial sum that must be made at the conclusion of a loan term. While they may be used with other loan types, this kind of payment is frequently related to mortgages, especially when using owner financing. A mortgage note, which is a legal document that details the borrower’s duty to repay the loan, including the interest rate, payment schedule, and any fees associated with the loan, would define the conditions of this loan.
Balloon payments are frequently employed to lower the monthly payment amount. The borrower pays lesser payments for a certain amount of time, then a bigger payment at the conclusion of the loan term rather than equal monthly payments (amortizing) over the course of the loan term. If you’re thinking about owner financing, you should understand how balloon payments operate and integrate them into your financing strategy.
2. Why set up a balloon payment?
For people with little income or savings, a balloon payment can be put up to assist borrowers to qualify for a greater loan amount. It can reduce the monthly payment amount throughout the course of the loan, allowing the person to build up some savings. And last, some borrowers might choose a balloon payment if they intend to refinance or sell the house before the balloon payment is due.
3. Balloon payment mortgage pros and cons
Pros:
- Lower monthly payments during the loan term
- Ability to qualify for a larger loan amount
- Can be useful for those who plan on refinancing or selling the property before the balloon payment is due
- If you are the note holder that is receiving payments, selling a real estate note with a balloon payment helps you to avoid having to wait for a lump sum
- payment.
Cons:
- Higher risk of defaulting on the loan
- Balloon payment amount may be difficult to pay off for the borrower
- Can be confusing for borrowers who don’t fully understand the terms of the loan
- Federal and state regulatory restrictions
4. Balloon payment example
Assume that you get a $200,000 loan with a 30-year amortization and a 5-year balloon payment. Your monthly payments are computed on a 30-year plan, which means that they are cheaper than if you paid off the loan in 5 years. For example, if the going interest rate is 5%, your monthly payments with a 30-year amortization would be $1073.64. You’ll owe a balloon payment of $183,657.46 at the conclusion of the 5-year period. However, if the loan is amortizing over 5 years with no balloon, the monthly payment amount would be $3774.25.
5. Where are balloon payments used?
Balloon payments are most typically utilized in mortgages, although they can also be employed in other forms of loans. They’re frequently employed when a borrower wants to reduce their monthly payment amount during the loan term.
6. Risks of a balloon payment
A balloon payment’s principal risk is that the borrower will be unable to make the final payment. If the borrower is unable to make the whole balloon payment when it is due, the lender may declare the loan to be in default and the borrower could lose their home. If the real estate market is not doing well or the home is damaged, refinancing or selling the property may be difficult, resulting in financial issues for the borrower. Iif the borrower attempts to pay off the loan early, they may be subject to prepayment penalties, which can increase the overall cost of the loan.
Another risk of balloon payments is that borrowers may grow too accustomed to the smaller monthly payments and would fail to appropriately plan for the high final payment. Borrowers may sometimes misjudge the financial load of the final payment, resulting in an inability to make the balloon payment when it is due.
7. How should a balloon payment be handled?
There are several alternatives for dealing with a balloon payment. Refinancing the loan before the balloon payment is due is one possibility. Borrowers who refinance might get a new loan with a longer duration and more reasonable installments. However, if the borrower’s credit score or financial circumstances have changed after they started the original loan, refinancing may not be a possibility.
Selling the home before the balloon payment is due is another possibility. The proceeds from the sale of the property can be used to pay off the debt. However, selling a home might take time, and the borrower may not be able to sell the home for the full amount owed.
Finally, consumers may be able to work with the lender to extend the loan term or convert the loan to a standard mortgage. These alternatives may enable the borrower to make payments over a longer period of time, reducing the total amount.
8. Laws governing balloon payments in mortgages
Balloon payments are governed by laws and regulations. For example, the Dodd-Frank Wall Street Reform and Consumer Protection Act compels lenders to only provide qualifying mortgages (QM). Qualified mortgages are loans that fulfill the Consumer Financial Protection Bureau’s guidelines (CFPB). QM loans must fulfill specific criteria, such as a 30-year loan duration and the prohibition of balloon payments.
There are, however, exceptions to the QM rule. Small creditors that operate in rural or underserved regions may be permitted to provide balloon-payment mortgages if certain requirements are satisfied.
Conclusion
For debtors who seek reduced monthly payments in the near term, balloon payment mortgages can be a valuable tool. They do, however, have risks and may not be suited for all borrowers. Before consenting to a balloon payment, borrowers should carefully weigh the benefits and drawbacks and ensure they have a strategy in place to handle the final payment. Borrowers and lenders should also be familiar with the rules and regulations governing balloon payments and qualifying mortgages.
