What is Balloon Mortgage?

A balloon mortgage3 is a loan that is paid as a large single, final payment. Typically, relatively small monthly payments are made, instead of a fixed monthly payment that gradually eliminates the debt2. But those payments will not be sufficient enough to pay off the loan before it comes due. Therefore, a final “balloon” payment needs to be paid at the end of the term, in order to to pay off the remaining loan balance.

The borrower’s monthly payment is calculated using a longer term, usually 30 years, to keep the monthly payment affordable. However, this lower payment means that at the end of the mortgage term, a very large balance remains. It can be zeroed out with a single payment, or the borrower may be able to refinance it.

The advantage of this loan is a lower mortgage rate and payment. However, the risk is that there is no guarantee of being approved for a new loan, nor any way of knowing what interest rates might be at that time. A balloon payment is for honest and qualified borrowers who have a good credit history. 

Borrowers interested in a balloon mortgage should also compare it to adjustable rate mortgages4, as it offers a little more protection for a similar interest rate.

A balloon loan is a type of loan that does not fully amortize3 over its term. Since it is not fully amortized, a balloon payment is required at the end of the term to repay the remaining principal balance of the loan. Balloon loans can be attractive to short-term borrowers because they typically carry lower interest rates than loans with longer terms. However, the borrower must be aware of refinancing risks as there's a risk the loan may reset at a higher interest rate.

Mortgages are the loans most commonly associated with balloon payments. Balloon mortgages2 typically have short terms ranging from five to seven years. However, the monthly payments through this short term are not set up to cover the entire loan repayment. Instead, the monthly payments are calculated as if the loan is a traditional 30-year mortgage. (See the mortgage calculator below for an example of how a conventional fixed-rate mortgage is calculated).

That said, the payment structure for a balloon loan is very different from a traditional loan. Here's why: At the end of the five to seven-year term, the borrower has paid off only a fraction of the principal balance, and the rest is due all at once. At that point, the borrower may sell the home to cover the balloon payment or take out a new loan to cover the payment, effectively refinancing the mortgage. Alternatively, they may make the payment in cash.

Pros and Cons of Balloon Loans

For some buyers, a balloon loan has clear advantages.

• much lower monthly payments than a traditional amortized loan1 because very little of the principal is being repaid; this may permit an individual to borrow more than they otherwise could
• if interest rates are high, not feeling the full impact of them because the borrower is just repaying interest
• if interest rates are high, not committing to decades of paying at that rate; the term is probably five to seven years, after which the borrower gets to refinance, possibly at a lower interest rate.