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June 15, 2020

What is a Balloon Payment?

You may have heard the term “balloon payment,” but do you know what it is? A balloon payment is a payment that pays off the balance of a loan at the end of a loan term. Typically, it’s much larger than the regular payments on the loan.

Why Are Balloon Payments Necessary?

When it comes to home financing, a balloon mortgage doesn’t completely amortize over the period of a loan like other typical loans. So, instead of paying on a mortgage over 30 years, a homeowner may make payments for only five to seven years. Then they are required to pay the rest of balance with a large (balloon) payment.

Borrowers must be aware of the inherent risks and be willing to subsidize a balloon payment out-of-pocket, without counting on the appreciation of their home to get a second mortgage to pay off the first. Otherwise, these types of real estate loans can be hazardous.

A Little History of Balloon Payments

In the 1970s, it was common to see balloon payment language as part of real estate financing due to the extremely high-interest rates (sometimes as high as 20%). To provide a breakeven point or cash flow for the real estate investor, they would sometimes take title subject to the existing loan and give the seller a second mortgage without any payments. This was called a “straight note.”

As long as the second mortgage was small, maybe less than 10% of the purchase price, not making any payments on the loan was an easy way to generate cash flow. This common practice presumed that the property would appreciate over the term of that second mortgage, which was typically about three years.

The Inherent Risk of Balloon Payments

What many borrowers tend to overlook is what happens if there is no appreciation. What if the value of the home declines? That’s how some homeowners during the Great Recession got into hot water with subprime mortgage lenders. One of the popular financing options at that time were Option ARM (adjustable rates mortgages) which contain interest-only payment options along with a balloon payment at the end.

During those times, a homeowner might have bought a home with no money down and took out an 80/20 combination loan. Then, both loans could be due and payable with a balloon payment at the end of the term. In declining real estate markets, it made it nearly impossible to sell a home and pay off both loans. As a result, the number of foreclosures and short sales skyrocketed. Of course, consumers eager to see their dreams of homeownership come true rarely thought about these things ahead of time and ended up owing more than the home was worth.

These situations are excellent reminders of why it’s crucial to work with a trusted home lender that will explain in detail the different home lending programs and help you make an informed decision. Don’t let an eager loan broker strong-arm you into going with a loan that might put you at risk. Primary Residential Mortgage always puts your needs first. If you have any questions, we are happy to assist you. Give us a call today!

 

Note: Opinions expressed are solely my own and do not express the views of my employer