What is a Balloon Mortgage?

Key Takeaways

• A balloon mortgage typically has a shorter loan term than a normal mortgage, which means that the borrower has pay off the loan in a shorter period.

• This type of mortgage can be beneficial for borrowers who are expecting a future increase in income or who only need the mortgage for a short period.

• A balloon mortgage is a useful tool for investors planning to extract equity from a property and liquidate it before the final payment comes due.

A mortgage is a type of loan that’s used to purchase real estate, in exchange for the borrower making payments to the lender over time. So, what’s a balloon mortgage?

A balloon mortgage allows the borrower to make smaller monthly payments for a set period (usually five to seven years) and pay off the remaining balance in one lump sum —known as a balloon payment.

This type of mortgage can be beneficial for borrowers who are expecting a future increase in income, a sharp rise in the value of the property in question, or for those who need the mortgage for a short period of time.

However, if the borrower is not able to make the lump sum payment at the end of the loan term, they may be forced to sell the property or take out a new loan to pay off the balance.

How Do Balloon Mortgages Compare to Normal Mortgages?

Balloon mortgages typically have shorter terms than normal mortgages. This means the borrower will make smaller monthly payments for a shorter period of time. At the end of the loan term, the borrower will be required to pay off the remaining balance of the loan.

Traditional mortgages have longer terms and may require the borrower to make larger monthly payments over a longer period time. However, the borrower will not be required to make a large payment at the end of the loan term as the prescribed amortization of the monthly payments will satisfy the loan at the end of the term.

Another key difference is that balloon mortgages typically have lower interest rates. This is because the borrower is taking on more risk by agreeing to make a large balloon payment at the end of the loan term.

How Does the Payment Process for Balloon Mortgages Work?

The payment process for a balloon mortgage is similar to that of a regular mortgage. The borrower will make their regular payments each month — for a set period, usually 5 to 7 years, and at the end of the loan term, they will owe the entirety of the remaining balance, which must be rendered as a single payment.

As an example, suppose a borrower seeks a balloon mortgage of $200,000 with a term of five years. The lender and the borrower agree on the rate of 6% per annum and also agree that the borrower will be making monthly payments of $1,687.71.

The amount of the balloon payment is typically the loan amount minus the monthly payments made over the duration of the loan’s term.

Calculating a Balloon Payment

The monthly payments, the loan amount, the interest rate, and the term of the loan will need to be known to calculate the balloon payment amount. This can then be accomplished using the following balloon mortgage formula:

FV = PV x (1+r)n – P x [(1+r)n – 1 / r]

Here:

• FV is the final lump sum payment (balloon payment)
• PV is the original loan amount
• P is the monthly payment amount
• r is the rate of interest
• n is the frequency of payments

In the example above, the balloon payment amount can be calculated by substituting the figures into the formula as shown below.

Substituting values from the example above:

FV = $200,000 x (1+6%/12)60 – 1,687.71 x [(1+6%/12)60 – 1 / 6%/12]
FV = $152,018.20.

The lender will first need to calculate the monthly interest rate by dividing the interest rate (6%) by 12. Then, the lender will need to calculate the number of payments the borrower will make by multiplying the number of years in the term (5) by 12.

Next, the lender will need to calculate the total loan amount by adding together the interest and the principal (initial loan amount). Finally, the lender will need to subtract the total monthly payments from the total loan amount to get the final balloon payment amount.

The fixed monthly payment in the first 5 years will be $1,687.71, and then the final balloon payment will be $152,018.20.

Thus, the total repayment amount will be $253,281.02, from which the total monthly payment will be $101,262.82, including a total interest payment of $53,281.02.

Here are some frequently asked questions to help you understand the pros and cons, and risks involved.

Alternative Investments and Portfolio Diversification

Diversification is an oft-employed tact for introducing a degree of insulation from market volatility to an investment portfolio. Traditional asset allocation envisages a 60% public stock and 40% fixed income apportionment. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

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In Summary

A balloon mortgage is a useful option for investors planning to extract equity from a property and liquidate it before the balloon payment comes due. Even better, a balloon mortgage enables them to carry the asset on their portfolio at a lower rate of interest and with smaller monthly payments. And, they could realize considerable gains — at lower costs — if their timing is right,

All securities involve risk and may result in significant losses. Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.