A balloon loan is a type of short-term mortgage. The balloon loan is often compared to the fixed-rate mortgage, as it shares some of its features. For example, a balloon loan offers the borrower a level payment amount over the term of the loan. However, unlike fixed-rate loans, balloon mortgages don’t amortize during the original term. Instead, this type of loan may have one of many maturity types.
When most borrowers take on mortgages, they obtain loans that will be fully repaid over a set amount of time. This length of time is referred to as the loan term. Balloon loans do have set loan terms, just like other types of mortgages. However, the monthly payments the borrower makes are not sufficient to repay the loan. As such, the borrower ends up owing a lump-sum payment, consisting of the remaining principle, at the end of the loan term.
Often, mortgage borrowers take on loans that last for 10, 15, 20, or even 30 years. Once the borrower makes his final monthly installment payment, he or she is usually cleared of the mortgage debt. Balloon loans often extend for about five to seven years, though term lengths do vary, and the balance of the mortgage loan is due at the end of the term; the debt is not cleared with a final installment payment. In the mortgage world, the end of the loan term is called maturity. Some people view the balloon loan as a poor choice because the borrower must be disciplined enough to plan for a large-sum payment at maturity.
While the disadvantage of having to come up with a large sum of money at the end of a rather short loan term is obvious, there are advantages to securing a balloon loan. One major advantage is that balloon loans often carry low interest payments, allowing the borrower to hold on to more cash over the loan term. The borrower can use the cash as she sees fit, perhaps even investing it in the hopes of earning more than what is required to repay the loan.
A balloon loan is not always forever. Often, these loans offer the borrower a conditional right to refinance into a new loan. This may save some borrowers who predict having difficulty coming up with a lump-sum payment. However, such borrowers may end up paying more over the length of the refinanced loan. This depends on a variety of factors, including the interest rate of both loans and any applicable penalties.