Understanding a Balloon Mortgage

by Investing School on May 16, 2011

A balloon mortgage is one in which the mortgage does not fully amortize during the life of the loan. This results in a large balance to be paid off at maturity. The considerable final payment is the reason for the nomenclature balloon. More often encountered in commercial real estate transactions than in residential ones, balloon mortgages can leave borrowers with a balance which exceeds their ability to pay when the final payment comes due.

Because so many borrowers find themselves unable to pay off the balance when the loan reaches maturity, a two step plan may be put in place. In this situation the balance is reset using the current market rates and this loan is fully amortized in the more traditional manner. This is not an option offered to every borrower; many factors, such as payment history and liens may prevent such an agreement being reached.

With no reset option available, borrowers are expected to pay the loan in full upon maturity, sell the property in question or refinance.

Clearly, the advantage of such a loan is that the payments will be lower since the principal isn’t fully amortized. Additionally, the total repayment is usually lower than that of a conventional mortgage. This provides the borrower with smaller payments during the life of the loan. The disadvantage is equally plain: there is a significant amount which remains due.

It is important to note that a balloon mortgage is different from an adjustable rate mortgage which is frequently used for the purchase of residential real estate.

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