A balloon loan is a short-term mortgage that offers level payment amounts, but does not amortize over the original term. The borrower owes a lump sum payment at the end of the loan term, which typically runs for five to seven years. Balloon loans often carry low interest payments, but the borrower must be disciplined enough to plan for the large payment due at maturity. Refinancing into a new loan is a conditional right for some borrowers.
A balloon loan is a type of short-term mortgage. The balloon loan is often compared to the fixed-rate mortgage because it shares some of its characteristics. For example, a balloon loan offers the borrower a level payment amount over the life of the loan. Unlike fixed rate loans, however, balloon mortgages do not amortize over the original term. Instead, this type of loan can have one of many types of maturity.
When most borrowers purchase mortgages, they obtain loans that will be repaid in full over a set period of time. This period of time is called the term of the loan. Global loans have fixed terms, just like other types of mortgages. However, the monthly payments the borrower makes are not enough to repay the loan. As such, the borrower ends up owing a lump sum payment, consisting of the remaining principal, at the end of the loan term.
Mortgage borrowers often take loans that last 10, 15, 20, or even 30 years. Once the borrower makes his final monthly payment, he is generally free of mortgage debt. Balloon loans often run for approximately five to seven years, although terms vary and the balance of the home loan is due at the end of the term; the debt is not canceled with a final payment in installments. In the mortgage world, the end of the loan term is called maturity. Some people view the balloon loan as a poor choice because the borrower must be disciplined enough to plan for a large payment when due.
While the downside of having to come up with a large sum of money at the end of a fairly short loan term is obvious, there are advantages to getting a balloon loan. One important advantage is that balloon loans often carry low interest payments, allowing the borrower to keep more cash over the life of the loan. The borrower can use the cash as they see fit, perhaps even invest it in the hope of earning more than is required to repay the loan.
A balloon loan is not always forever. Often these loans offer the borrower a conditional right to refinance into a new loan. This can save some borrowers who predict they will have a hard time getting a balloon payment. However, such borrowers may end up paying more over the life of the refinanced loan. This depends on a variety of factors, including the interest rate on both loans and any applicable penalties.
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