A balloon loan allows an individual to purchase property, such as a home or car, on a monthly payment plan that features one large lump-sum payment at the end of a fairly short term, which is known as the balloon payment. Until the balloon payment is reached, the loan's payments are generally calibrated to a below-market interest rate. Balloon loans carry with them several advantages and disadvantages depending on an individual's needs.
Home mortgage balloon loans can be financed for a variety of time periods, but many are for either three-, five- seven- or 10-year terms. On a 30-year mortgage with fixed interest, the last actual house payment will be equal to the first. With a balloon loan, the last payment is for the remaining balance on the loan. So a 10-year balloon mortgage will typically feature 10 years of monthly payments on a 30-year loan schedule, with the remaining balance of the loan due at the end of 10 years.
While a home buyer could opt to pay off the balloon payment on a mortgage loan with cash or savings, many choose alternative methods of financing. Some lenders allow the balloon loan to be repackaged as an adjustable-rate or fixed-rate mortgage. However, many homeowners choose to shop around for refinancing through a new financial institution that will offer a competitive interest rate on a new loan. When the mortgage is refinanced, the balloon loan lender is paid in full by the bank that refinances the loan.
A balloon loan gives provides a low monthly payment to individuals who plan to flip a home quickly, which leaves more funds available for further investment in real estate or savings. Balloon financing can also work well for people with jobs that require frequent relocations.
The main disadvantage to a balloon loan is the need for refinancing at the end of the loan period. Refinancing or the conversion of the balloon loan to an adjustable-rate or fixed mortgage requires additional closing costs and fees from the homeowner that could be avoided with a traditional mortgage. Another disadvantage is that because the full amount of the loan is not being amortized, the monthly payments make very little dent in the principal amount owed. This means that the buyer will build very little equity in the home.
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