Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Balloon Mortgage

What it is:

A balloon mortgage is a mortgage with a large payment made near or at the end of a loan term.

How it works (Example):

Unlike a loan whose total cost (interest and principal) is amortized -- that is, paid incrementally during the life of the loan -- most or all of a balloon mortgage's principal is paid in one sum at the end of the term. That sum is called the balloon payment (or sometimes the bullet). Sometimes the interest is collected as part of the balloon payment as well, though in many cases the loan is interest-only during the term of the loan with only the outstanding principal due at the end.

For example, suppose someone takes out a mortgage for $417,000. To avoid a lengthy graphic with 360 payments for a 30-year mortgage, we'll assume that the mortgage is only two years long (this is an unrealistic loan term, but it works for our purposes).

In a normal mortgage scenario (the left side of the graphic), the borrower would make a series of equal payments that are composed of principal repayment and interest payment so that by the end of the loan term, the borrower has paid down all of the loan. For a balloon mortgage (the right side of the graphic), however, the monthly payments might be extremely low for most of those two years—because at the end of the two years the borrower has to make a giant balloon payment to pay off the loan.

Why it Matters:

Balloon mortgages can be common, and they have the advantage of lower initial payments. They can be preferable for people who have near-term cash flow issues but expect higher cash flows later, as the balloon payment nears. The borrower must, however, be prepared to make that balloon payment at the end of the term. Sometimes the lender will roll that amount into a new mortgage for the borrower. This is often called a two-step mortgage.

[If you're ready to buy a home, use our Mortgage Calculator to see what your monthly principal and interest payment will be.]