A balloon mortgage loan is a mortgage which is amortized over a longer period of time than the term of the mortgage. “Term” refers to the length of the mortgage agreement. Balloon payment mortgages most commonly refer to mortgages which are amortized over 25 years or more, but which have a term of 5 years or less. These mortgages are also known as short-term mortgages or simply term mortgages.
Balloon mortgage loans are usually negotiated for terms of between 6 months and 5 years, and are usually amortized over 25, 30, 35, or 40 years. During this period of time, the interest rate is fixed. However, some balloon mortgage loans may offer introductory teaser rates and then raise the interest rate later in the term.
At the end of the mortgage term, the balance of the principal is due. This is what is known as a balloon payment, because it will always be much, much higher than the previous mortgage payments. If the borrower did not fully understand the terms of the balloon mortgage loan, payment shock is likely.
When the balloon payment comes due, the borrower may pay off the balance in full. Alternately, the borrower may choose to refinance the mortgage, which usually means another balloon mortgage loan.
Many borrowers choose balloon mortgage loans when they expect interest rates to fall. That way, they are only locked into the higher interest rate for a few years, rather than for the entire amortization period. As a result, they may end up saving thousands of dollars in interest. They may also save on mortgage penalty fees, which would otherwise be incurred if they try to get out of the higher interest rate mortgage early.
Another reason to choose a balloon mortgage loan is if the borrower expects to sell the house soon. For example, a long-term contract employee may choose to buy a house or condo instead of renting, then sell it at the end of his contract when he plans to move away. The sale of the house or condo provides the funds to pay off the balloon payment when it comes due.
In the mid-2000s, a common reason for choosing a balloon mortgage loan was to cash in on rising real estate values. Some of these balloon mortgage loans were even based on negative amortization, where the scheduled payments over the term of the mortgage covered less than the interest. Teaser rates sometimes created an equivalent situation over the first year of the mortgage. Yet as long as real estate prices kept rising at a higher rate than the rate of interest, even these borrowers could sell their properties for enough money to pay off the balloon payment plus some profit.
However, once real estate prices fell, many borrowers were left stranded after the market value of their property fell below the necessary balloon payment. If they could not raise the money from other sources or make arrangements with the lender to sell short, that property went into foreclosure.
These practices contributed to the severity of the real estate crash in 2007. As a result, balloon mortgage loans have become much less common in recent years.