A balloon mortgage is one where the monthly payment does not change for a particular period of time; then, at the end of that time, the entire balance of the mortgage comes due. For instance, a balloon mortgage of 7 years charges a monthly payment that remains the same until the final payment at the end of seven years; then whatever is left of the mortgage loan must be paid in its entirety.
How Is a Balloon Different from an Adjustable Rate Mortgage (ARM)?
The rate on a balloon mortgage is typically lower than the initial rate on an ARM, just as the initial rate on an ARM is generally lower than a fixed rate mortgage.
Interest Rate/Payment Caps
Balloon mortgages don’t have them. ARMs do. This means an ARM offers the borrower more protection from increasing interest rates or payments. At the end of a balloon mortgage if the borrower is forced to refinance the balloon, it will be at the current interest rate. Depending on the economy, this could be much higher than the original rate.
Impact of Credit
An ARM also protects the borrower whose credit rating is decreasing due to late or non-payment of debts. In a way, the lender is stuck with someone who now has poor credit. With a balloon mortgage, refinancing will include revisiting the borrower’s credit rating. If it has gone downhill the lender can levy an even higher interest rate or refuse to refinance rather than risk the money.
Someone with an ARM need not refinance unless he chooses to do so. Someone with a balloon mortgage who cannot pay off the balloon in full doesn’t really have any wiggle room. He must refinance, modify the mortgage, or lose the property.
Which One Is Better?
The answer to this question, as with so many, is…it depends. If you are reasonably certain that you can either pay the balloon at the end or that you will sell the home long before the balloon is due, the lower rate on a balloon mortgage might be just the ticket.
However, an ARM offers a great deal more protection from unsustainably high monthly payments, the need to refinance when the interest rates are not favorable, and it only requires your credit rating to be judged once.
How much risk are you willing to bear for that (probably only) slightly lower interest rate to be worth it? Considering the payment amount a balloon mortgage has at the end, the risk is probably not worth it if you intend to stay in the house longer than the mortgage period.
Of course, you could always sign up for a balloon mortgage then refinance to an ARM or fixed rate loan several months prior to the balloon coming due. Or you may be able to get your loan modified. Just remember that with this plan you will be paying financing costs, something you would not have to do if you had gone with the ARM in the first place.