Do Balloon Loans Protect Mortgage Borrowers?
August 24, 1998, Revised January 28, 2010

"You said recently that a borrower must refinance a balloon loan? Isn't the lender obligated to extend a balloon loan at the borrower's request? Isn't that valuable protection?"

It is true that at the term of a balloon loan, usually 5 or 7 years, the lender is contractually obligated to refinance it, subject to certain conditions. The question is, how valuable is this obligation to the borrower? In my judgment, because of the conditions that hedge the commitment, it is worth little or nothing.

If you take out a 5-year balloon today, the lender's obligation to refinance is at the rate the lender will be charging in 5 years. But under normal conditions, many lenders will be interested in refinancing a balloon loan and you will want to shop for the best deal available at the time. The lender offering the best deal on a balloon loan in 5 years is unlikely to be your current lender. Besides, changes in your financial circumstances or in the market during the 5 years may call for a different type of loan. Under these circumstances, the refinance commitment by the original lender is worth very little.

A commitment by the original lender might be valuable under adverse circumstances, of which three are worth mentioning:

    1. An economic reversal to the borrower that threatens his ability to pay. However, in all the balloon contracts I have looked at, the lender need not refinance the loan if the borrower has been late on a single payment in the preceding year. The borrower is OK if his credit score has dropped, but only if he has not missed any payments.

     2. An explosion in market interest rates. But in the balloon contracts, the lender is off the hook if the lender's new rate is more than 5% above the old rate.

    3. A tightening in underwriting requirements such that the borrower does not meet the new requirements. This was the situation after the financial crisis that erupted in 2007-8. The borrower is protected against the possibility that the lender will  say "While we thought you were good enough 5 years ago, we don't think you are good enough today."

The bottom line is that under normal circumstances you won't need a commitment from your existing lender because many lenders will want to deal with you. Under some adverse circumstances, the lender's commitment doesn't hold, but you are protected against the imposition of tighter underwriting requirements that you don't meet.
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