A balloon payment is a lump-sum payment at the end of the term of a loan when the monthly payments over the term are not sufficient to amortize the loan. For example, at the end of an interest-only loan, the remaining balance must be made with a lump sum, or balloon payment.
There are variations that fall between interest-only and full amortization loans. These are loans that base the payment on a term different from the actual term. A typical one is a 30/5 loan. This means that the payment is based on thirty years, but the loan must be repaid in five years. The required payments are not enough to pay off the loan, creating the balloon payment at the end of the five-year term.
The obvious question is, what happens at the end of the five-year term? You can, of course, pay the balloon by refinancing. You are betting that rates will not rise too much in that five-year period.
You can also sell the property. If your plan in getting this loan is to sell before the balloon is due, that is a good reason. The interest rate may be lower on the balloon mortgage compared to an adjustable rate mortgage.
Today’s balloon mortgages will usually have a refinance clause. They will typically guarantee that the lender will either extend the term of the existing loan or give the borrower a new loan. There are usually some fees involved in the modification and always in the refinance. In addition, there are generally two requirements.
1. First, the borrower must not be delinquent on the payments.
This just makes sense, if you cannot pay your existing loan, why would the lender want to extend it or give you a new loan?
2. Second is the interest rate. You are going to get the extension or new loan at the prevailing rates five years after the original loan. You can see the problem if rates rise dramatically. Unless the lender will guarantee a limit on the interest rate for the modification or refinance, you are at the mercy of the market.
An alternative is an adjustable rate mortgage with a low interest rate for the first five years. It will probably cost you more than the balloon mortgage, but it will have a limit on the amount that the interest rate can increase after the initial five-year period.