May 4, 1998, Revised November 18, 2006, November 20, 2008

What Is a Balloon Loan?

In some respects, a balloon loan looks very much like a 30-year fixed-rate mortgage (FRM). The payments are calculated in exactly the same way. In both cases, the payment is the amount required to pay off the mortgage in full over 30 years. Where the two instruments differ is that, after a specified period, generally 5 or 7 years, the outstanding balance (the "balloon") has to be repaid in full.

[Note: In 2006, 15-year balloons became fairly common, but as the second mortgage component of piggyback arrangements used to avoid payment of mortgage insurance on loans with down payments of less than 20%. See What Is a 15-Year Balloon? The financial crisis that erupted in late 2007 resulted in the disappearance of piggyback balloons.]

For example, on a $100,000 loan at 6%, the payment on a 7-year balloon and a 30-year FRM is $599.56. On the balloon, however, the balance of $89,638 after 7 years has to be repaid in full. If the borrower is still in the house, unless he has come into a windfall, the balloon loan must be refinanced.

In other respects, a balloon mortgage resembles an adjustable rate mortgage (ARM) with an initial rate period equal to the balloon period. A 7-year balloon, for example, is usually compared to a 7-year ARM. Both have a fixed-rate for 7 years, after which the rate will be adjusted. The two instruments can be viewed as close substitutes, with advantages and disadvantages relative to each other.

Advantages of a 7-Year Balloon Over a 7-Year ARM

One advantage the balloon has over the comparable ARM is simplicity. At the end of the 7 years, the borrower with the balloon pays it off by refinancing, and the new loan carries the market rate prevailing at the time. The borrower with the ARM, in contrast, is subject to a rate adjustment based on rules spelled out in the loan contract, which many borrowers find difficult to understand.

The second advantage of the balloon is that the price is lower. When I checked on November 18, 2006, the rate on a 7-year balloon was lower than the rate on a 7-1 ARM by between .125% and .25% in rate. Lenders charge less for a balloon because the rate is fully adjusted to the market after 7 years, whereas on the ARM the adjustment may be limited by interest rate caps.

Advantages of a 7-Year ARM Over a 7-Year Balloon

The major advantage of the ARM to a borrower is that it provides valuable protection against a future interest rate explosion, which is unlikely but could happen. Between 1977 and 1981, for example, mortgage rates increased by about 9%. If that experience were repeated, the rate on a 6% balloon would rise to about 15% whereas the rate on the comparable ARM would rise only to about 11-12%. The limiting factor would be the maximum rate on the ARM.

A second advantage of the ARM is that it does not penalize the borrower whose credit has deteriorated during the 7-year period. The ARM deal is done and the lender can’t get out of it if the borrower turns out to be an unsteady payer.

On a balloon, in contrast, the balance is due at the end of year 7, and while the lender commits to refinance the loan at the market rate, that rate can reflect deterioration in the borrower’s credit. Indeed, in the balloon contracts I have seen, the lender has no refinance obligation at all if the borrower has been late a single time in the previous 12 months.

A possible third advantage of the ARM is that the ARM borrower need not but the balloon mortgage borrower does incur refinance costs at the end of year 7. This must be qualified, however. If the rate on the 7-year ARM adjusts to a level that is higher than the rate on a new 7-year ARM, which is the case more often than not, the ARM borrower will have to refinance to get the benefit of the lower rate.

For example, assume the ARM rate is 6%, the index at the time of adjustment is 5%, and the margin is 2.25%. Then the ARM rate will jump from 6% to 7.25%. If new 7-year ARMs are going for 6%, the ARM borrower must refinance to retain the 6% rate.

The Upshot

I would select the balloon only if I were 90% sure that I would be out of the house before the end of the balloon period. If I was less sure, the small price advantage of the balloon would not compensate for the greater risk.