Balloon Mortgage: What It Is and How It Works
A balloon mortgage allows you to enjoy low monthly payments for several years — with a big catch. Your final payment amount “balloons” sharply, potentially leaving you with a bill that’s far higher than what you’ve been paying. If you understand the risks and unusual features of a balloon mortgage, this loan type can make sense. Still, it’s best to go in with a plan for how you’ll manage the hefty final payment.
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What is a balloon payment mortgage?
Balloon mortgages are short-term loans that begin with a series of fixed payments and end with a final, lump-sum payment. That one-time payment is called a balloon payment because it’s often at least twice as much as the previous ones, leaving many borrowers with a final bill for tens of thousands of dollars (or more).
A balloon payment mortgage for a residential property isn’t easy to find today, in large part because these loans don’t meet qualified mortgage (QM) requirements. Non-QM loans have features that are known to increase the risk of mortgage default, which can impact individual borrowers, but also the mortgage industry and overall economy. The rules for QM loans were established by Congress and the Consumer Financial Protection Bureau (CFPB) in response to the global financial crisis in 2007 to 2008.
How does a balloon loan work?
A balloon mortgage comes with low payments during the initial period, but they won’t be enough to cover the total loan cost. That’s why, at the end of your fixed payment schedule, you’re left with a large outstanding balance that needs to be paid in full. This payment structure is called “non-standard amortization.”
Amortization is how lenders calculate how much you’ll need to pay each month if you want to use a series of equal payments to completely repay a loan. To “fully amortize” a loan over 30 years means to calculate how much the borrower needs to pay each month to pay it off by the end of that 30-year period.
A balloon mortgage usually comes with a shorter loan term than a traditional mortgage — typically five or 10 years. Borrowers may plan to refinance or sell the home to avoid making that large final payment at the end of the term. Of course, if you have the cash, you can pay off a balloon mortgage early or when the balloon payment comes due.
How to calculate a balloon payment
There are two ways lenders usually calculate the low, fixed-rate payments you’ll pay during the majority of your loan’s term:
- Amortization over a period that doesn’t match your loan term. Your lender may calculate your fixed payments as if you had a 30-year loan, even though your actual term may be just 15 years. You can make these affordable payments for a while, but whatever outstanding balance is left when you reach the end of your loan term will be your balloon payment amount.
→ This type of balloon mortgage is sometimes referred to as an “X due in Y” mortgage (for example, “30 due in 15”). “X” is the amortization period and “Y” is the loan term.
- Interest-only payments. You’re only required to pay enough each month to cover the interest charges. This leaves your principal balance untouched until you arrive at your balloon payment.
Balloon mortgage example
To illustrate how a balloon mortgage is repaid over time, we’ll look at two balloon payment examples: one with interest-only payments and one with payments that cover both principal and interest.
This balloon payment example has a 10-year term on a $280,000 loan amount with a 6.80% interest rate, but the monthly payments are based on a 30-year amortization, which makes them much smaller than a fully amortized 10-year loan.
| Year | Monthly payment |
|---|---|
| 1 | $1,825 |
| 2 | $1,825 |
| 3 | $1,825 |
| 4 | $1,825 |
| 5 | $1,825 |
| 6 | $1,825 |
| 7 | $1,825 |
| 8 | $1,825 |
| 9 | $1,825 |
| 10 | $1,825 |
| Final balloon payment: | $240,958 |
Even though the balance decreases slightly since the loan payments include both principal and interest — it’s not nearly enough to pay off the loan by the due date.
This five-year balloon payment example uses the same $280,000 loan amount and 6.80% rate.
| Year | Monthly payment |
|---|---|
| 1 | $1,587 |
| 2 | $1,587 |
| 3 | $1,587 |
| 4 | $1,587 |
| 5 | $1,587 |
| Final balloon payment: | $280,000 |
Because the payments are interest-only, the principal balance doesn’t decrease at all during the five-year term.
How does a balloon mortgage differ from other loans?
In addition to having a lump-sum payment due at the end of the loan term, balloon mortgages differ from other loan types in a few ways:
Lenders
One significant difference is the type of lenders that provide balloon mortgages. Balloon payment loans are typically offered by small or private lenders and can be reserved for certain types of lending, like construction.
Requirements
Balloon mortgage lenders establish their own requirements. They can be stricter, requiring higher credit scores and down payment amounts.
However, they can also be looser in other ways, if the lender is catering to a customer base that needs alternatives to standard mortgage qualifications. They may not require the same level of income documentation or may allow you to skip a home appraisal, for example.
Interest rates
Balloon mortgage rates are typically higher than your average 30-year fixed-rate mortgage because lenders are taking on a great deal of risk. In some cases, though, the rates you’re offered may be temporarily lower. If you’re planning to refinance the loan before the balloon payment is due, you’ll still have a large balance and there’s no guarantee mortgage rates will have dropped by then.
Curious where rates are headed? Read our current mortgage rates forecast.
Should you take out a balloon mortgage?
For most people, taking out a balloon payment mortgage is a pretty big risk. Even if you have a plan to refinance or sell before the final payment is due, the market could change and make those options impossible. Then, you’ll be stuck with a very large payment and, if you’re unable to come up with the cash, you could face foreclosure.
A balloon payment mortgage makes the best sense for borrowers who:
Already have the final payment
Borrowers who have the funds to make the payment may wish to invest the money elsewhere until the balloon payment is due. In this case, taking on a balloon mortgage is less risky because you already have the money set aside for the final payment.
Expect a lump sum
A balloon mortgage could make sense if you’re expecting an inheritance, bonus or other windfall and can use those funds to make the balloon payment when it comes due. However, the lump sum needs to be guaranteed — not just something you expect, or hope, will happen before the final payment.
Expect an income increase
Borrowers who expect an income boost in the near future may want to leverage a balloon loan to purchase a home while their income is still low. For example, if you’re a medical student but feel confident that your income will increase significantly once you graduate, a balloon mortgage can get you into a home without unnecessary waiting.
Want short-term financing
Investors looking to flip a house often take out balloon mortgages to buy and rehab a home and sell it within a short time. However, as a borrower, you need to be careful with these loans because they often come with high interest rates and fees.
Plan to sell soon
A balloon payment could make sense for homeowners who plan to live in the property for a few years and sell it before the lump sum is due. However, if the home’s value decreases during that time, you may have to make up the difference between your sales price and outstanding mortgage balance.
Balloon mortgage pros and cons
| Pros | Cons |
|---|---|
Affordable: You'll have low initial payments No waiting: You can buy a home sooner if you know you'll later have additional income Quick turnaround: You may have a faster processing time than with a traditional lender Less hassle: You'll have fewer documentation requirements Flexibility: You can finance investment properties | Risk of foreclosure: You could lose the home if you default on the loan Future debt: You may have to take out another loan to cover the balloon payment A longer timeline: You'll build home equity more slowly Tougher requirements: You may have a harder time qualifying Loan costs: You'll have higher interest rates |
How to pay off a balloon mortgage
Some borrowers are able to make the balloon payment by saving up a lump sum during the fixed payment period, or using expected funds like a bonus or inheritance. However, many won’t be able to pay the balloon payment all at once. Here are some other options to pay off a balloon mortgage.
→ Refinance. One way out of a balloon payment is to refinance the loan to another mortgage before the balloon payment is due. Most lenders require minimum amounts of home equity to refinance a mortgage, however, so this might not be in reach — those low initial monthly payments may not have helped you build enough equity.
→ Sell the home. Borrowers unable to make the balloon payment by the due date can sell the property to avoid defaulting on the loan and potentially facing foreclosure.
→ Pay more during the initial period. Assuming the loan doesn’t have a prepayment penalty, paying more than your minimum payment amount requires you to during the initial period will reduce the principal balance due at the end of the loan term.
→ Negotiate an extension. Homeowners unable to make their balloon payment on time may be able to negotiate an extension. This option is likely to come with significant fees, though, and may result in only a short-term extension.
Balloon mortgage alternatives
Construction-to-permanent loans
Historically, people who wanted to finance a newly constructed home had to obtain interim construction financing from a bank. But lenders can now issue one-time construction loans.
These loans typically begin as interest-only loans during the construction phase and convert to mortgages with principal and interest payments once the construction phase ends. This option can provide a safer alternative to a loan with a balloon payment.
Adjustable-rate mortgages
An adjustable-rate mortgage (ARM) can provide some of the same benefits as a balloon loan, but with different risks. ARMs typically carry lower interest rates and monthly payments at the start of the loan, and homebuyers can usually qualify for a larger mortgage when they first buy a home.
But, unlike balloon loans, the entire ARM loan balance doesn’t come due at once. Instead, the interest rate and payments adjust throughout the loan term after an initial fixed-rate period.
You can ask your lender to estimate the highest payment you might face under the ARM to help you decide if the initial savings are worth the risk.
FHA graduated payment mortgages
The Federal Housing Administration (FHA) offers graduated payment mortgages, which are home loans with monthly payments that increase over several years. This loan program is a safe alternative to balloon mortgages because it has built-in features that help ensure borrowers can afford the new payments as they increase.
Longer-term mortgage
A mortgage with a longer term, such as 40 years, will have a lower payment compared to a loan that is amortized over a shorter time frame. Keep in mind you may not qualify for a 40-year loan unless you’re working with your lender in a loan modification program.