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Balloon Mortgage Explained

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Those interested in alternative mortgage financing may be wondering what is a balloon mortgage. A balloon mortgage is a form of financing a house that is a cross between an adjustable rate mortgage (ARM) and a fixed rate mortgage. While a balloon mortgage can allow you to purchase a house or lower initial monthly payments, there are many risks associated with a balloon mortgage. Therefore, before selecting this or any other type of alternative mortgage financing, it is essential to get a clear understanding of what is a balloon mortgage and how they work.

What is a Balloon Mortgage

A balloon mortgage is a mortgage in which your interest rate is fixed for a set period of time. This set period of time is usually five to seven years long. During that period of time, your mortgage payments will be determined by an unchanging interest rate and you will know exactly how much you have to pay every month. In this sense, a balloon mortgage is very similar to a fixed rate mortgage.

However, a fixed rate mortgage usually lasts for fifteen to thirty years and if you make your mortgage payments each month and don't refinance, at the end of the term of your fixed rate mortgage loan, your mortgage balance will be paid in full and you will own your home free-and-clear.

In a balloon mortgage, on the other hand, at the end of the specified period, the remaining balance will come due on your mortgage. So, for example, if you took a $100,000 balloon mortgage and paid off approximately $15,000 in principle over 5 years, then at the end of that 5-year period, the remaining balance of $85,000 would become due.

Most people, of course, do not have this $85,000 balance at the end of 7 years to pay off their mortgage in full. The premise, at that point, is to refinance the loan or to take a new mortgage for the remaining balance. When you refinance, you can refinance into any type of loan that you want and that you can qualify for. Your interest rate for this new loan will be fixed based on prevailing market rates at the time. In this sense, a balloon is similar to an adjustable rate mortgage, because at the end of the seven year period, your interest rate will adjust or change.

Why Choose a Balloon Mortgage

People choose a balloon mortgage because it allows you to have lower monthly payments and a lower interest rate for the first five to seven years you own your home. This may seem attractive to borrowers who believe that their incomes will go up or that interest rates will go down. Others choose a balloon mortgage because they do not think they will stay in the house for the full five or seven years until their balloon becomes due, so they want to take advantage of the low interest fixed interest rates for the duration of the time they are in the house.

Many people believe these are simpler than a standard adjustable rate mortgage, since your loan may adjust only once when you take out a new loan to pay off your "balloon" payment. Furthermore, when the interest rate does adjust when you take your new loan, it is based on prevailing market rates and not on an index specified in an ARM contract.

Risks

The major risk associated with a balloon mortgage is that you will be unable to refinance into a loan that you can afford when your balloon payment comes do. If your property values fall, or if your credit or income goes down before your balloon comes due, you may not be able to qualify for a new mortgage to pay off the balance of the balloon. In that case, the bank may foreclose on your house if you are unable to pay what you owe.

Other risks include the possibility that interest rates will rise, and thus you will need to refinance into a more expensive mortgage when the balloon becomes due, or that property values will fall and you will be unable to sell your house when you planned to. Again, this may cause you to be unable to afford to make your house payments.

Because of these risks, it is essential to fully understand what is a balloon mortgage before choosing this method of financing.

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