Getting a mortgage to buy a house can help you to achieve your dream of homeownership, but it’s also a huge responsibility. It’s essential to understand the terms of your mortgage before you sign it. Not doing so can lead to unexpected expenses down the line.
One of the most important things to know before you get a mortgage is that not all mortgages are created equal. A traditional, fixed-rate mortgage requires the borrower to make equal monthly payments for the duration of the term. Others offer lower payments at first and can be risky if you don’t know how they work. Here’s what you need to know about balloon mortgages and interest-only mortgages.
A balloon mortgage is a mortgage where you pay amounts each month that are lower than the payments on a traditional mortgage. You may pay only interest at first, or you may pay mostly interest with a bit of principal included as well.
The “balloon” part refers to the payment you’ll be required to make at the end of the mortgage term. This payment is always larger than the monthly payments and may be as much as the entire original mortgage amount.
An interest-only mortgage is a type of mortgage where the monthly payments are, as the name implies, only interest. There may or may not be a balloon payment at the end of an interest-only mortgage. It’s more common for the monthly payments to increase after an initial, interest-only period of between five and 10 years.
The easiest way to understand how balloon payments work is to look at examples. We’ll start with an abbreviated amortization table for a traditional, fixed-rate mortgage. For these examples, we’re assuming a purchase price of $350,000 with a 20% down payment, leaving a mortgage amount of $280,000 with a 5.7% interest rate.
Month |
Payment |
Interest |
Principal |
Balance |
|
1 |
$1,625.12 |
$1,330 |
$295.12 |
$279,704.88 |
|
60 |
$1,625.12 |
$1,234.80 |
$390.32 |
$259,567.43 |
|
180 |
$1,625.12 |
$935.86 |
$689.26 |
$196,333.84 |
|
360 |
$1,626.40 |
$7.69 |
$1,618.71 |
$0 |
What you can see from this example is that the payments stay the same, with a slight uptick in the final month to bring the balance to zero. As the term of the mortgage progresses, the ratio of interest to principal in the monthly payments decreases, which means that the homeowner gains equity in their property.
Now, let’s look at an example of a balloon mortgage. For the sake of simplicity, we’ll use the same dollar amounts and interest rate. This is what an interest-only mortgage with a balloon payment would look like. We should note that balloon mortgages often have shorter terms than traditional mortgages. For this example, we’ll assume a 15-year term.
Month |
Payment |
Interest |
Principal |
Balance |
|
1 |
$1,330 |
$1,330 |
$0 |
$280,000 |
|
60 |
$1,330 |
$1,330 |
$0 |
$280,000 |
|
100 |
$1,330 |
$1,330 |
$0 |
$280,000 |
|
180 |
$281,330 |
$1,330 |
$280,000 |
$0 |
This is an extreme example to show you how a balloon mortgage works. Most interest-only mortgages offer the borrower a chance to pay only interest for a fixed period, usually five, seven or 10 years at most. After that, the mortgage switches to a traditional amortization table where the borrower’s payments increase to include both interest and principal.
The most notable thing about a balloon mortgage is that the borrower is required to make a large lump sum payment at the end to pay the remaining balance. The large payment can be a problem for homeowners.
The other issue with balloon or interest-only mortgages is that even with the same principal amount and the same interest rate, you’ll pay more interest if all you pay is interest. That’s because with a traditional mortgage, you’re paying down the principal each month. When the interest rate stays the same, that translates to lower interest amounts as your principal balance decreases.
To do an apples-to-apples example, with a 15-year traditional mortgage of $280,000, your total interest payments would be $137,178.34. With the same mortgage with interest-only payments and a balloon payment at the end, you could pay as much as $239,400.00 in interest on the same principal, which comes out to more than $100,000 in extra interest payments.
The best way to spot a balloon payment or interest-only payments is to look at an amortization schedule for the loan you’re considering. Any reputable lender should be willing to crunch the numbers and figure out what your monthly payments will look like. Many lenders, including Addition Financial, have free mortgage calculators on their websites.
On the amortization table, look for any changes in the monthly payments. As we mentioned above, interest-only mortgages often change after an initial, interest-only period. If you have the same payments for five years and those payments then increase, you’re looking at an interest-only mortgage with a 5-year interest-free period.
It’s worth noting that most interest-only mortgages come with adjustable interest rates. For that reason they are often described with two numbers. The first indicates the number of years when you’ll pay only interest, and the second indicates how often the interest rate is subject to change. For example, a 7/1 interest-only mortgage would include interest-only payments for seven years. At the end of that time, the interest rate would be subject to adjustment once a year.
Balloon payments are easy to spot on amortization tables because they are significantly larger than the other monthly payments. By definition, a balloon payment is at least twice as large and may be many times as large as a regular monthly payment. The best way to tell if your mortgage includes a balloon payment is to look at the payment amount for the final month of the term.
You can also spot a balloon payment on the first page of your Closing Disclosure. The Closing Disclosure is a five-page, standardized form that must be used by all lenders in the United States. In the Loan Terms box on the first page, the lender must disclose the following information:
If your lender types YES next to the balloon payment, it means that a balloon payment is part of the mortgage agreement.
When people are worried about making monthly payments, an interest-only mortgage or a mortgage with a balloon payment may seem like a good idea. It can help to keep monthly payments low.
We’d be remiss if we didn’t mention the risks associated with these mortgages, which were partly responsible for the housing collapse of 2007-2008:
During the housing crisis, many homeowners found themselves unable to pay their mortgage lenders when their monthly payments increased. Those with little equity in their homes were upside-down on their mortgages meaning that they owed more than their homes were worth on the market. Unable to sell, many lost their homes to foreclosure.
There are potentially some limited circumstances where an interest-only or balloon mortgage might make sense. For example, professional house-flippers often prefer interest-only mortgages because they don’t plan to keep the house long enough for the higher payments to become an issue. They do the work and, with any luck, they resell the house for more than the mortgage plus the cost of renovations, allowing them to pay off the remaining balance and turn a profit. (We should note here that if this is something you want to do, check to see if the mortgage comes with an early payment penalty.)
If you believe you won’t live in your house for long, a balloon payment might not seem like a big deal – and the same goes for an interest-only mortgage. However, it’s important to weigh the potential savings against what would happen if you weren’t able to move and needed to make those higher payments.
There are some things about interest-only mortgages and balloon payments that may seem appealing. However, these mortgages exist in a gray area that may border on predatory lending, particularly if lenders don’t ensure that potential borrowers understand the risks associated with them.
Are you ready to buy a home? At Addition Financial, we offer a variety of mortgage options that can help you to achieve your dream of homeownership. Click here to apply now!