Balloon Mortgages Remain in Vogue
Okay, perhaps in vogue is an overstatement. But the fact that these mortgages are still available in the wake of the housing bust is frankly amazing. At least one online lender is offering these loans, although this time it has taken steps to mitigating its exposure by requiring a large down payment. “Company officials said they’re aiming these loans at customers who have demonstrated an ability to save money, hence the 25 percent down payment requirement. And they say various features of the loan will allow borrowers to pay off their homes more quickly than if they took out a traditional mortgage.”
Before I get ahead of myself, let me first briefly explain what exactly is meant by the term balloon mortgage. In a nutshell, it’s a “mortgage which does not fully amortize over the term of the note, thus leaving a balance due at maturity.” While the borrower makes payments (interest and principal) in accordance with a normal 15 or 30 year amortization schedule, the loan must be paid off after a fixed duration, usually 5 or 7 years. This lump-sum payment of the remaining balance is known as a “balloon.”
Irrespective of the size of the downpayment, balloon mortgages are still considered risky by most experts. The reason being that the average borrower won’t be able to afford the balloon payment, and will be forced into refinancing. If interest rates have increased and/or the borrower’s credit has deteriorated in the interim period, then this could prove both difficult and expensive. For this reason, balloon mortgages have received special scrutiny from regulators. “Under the new Fed proposals…Buyers also would be presented with a one-page document, in question-and-answer format, warning about risky loan features such as negative amortization and balloon payments…”
The main advantage of the balloon mortgage (cynics would say ‘the main way that lenders entice borrowers’) is its initial interest rate, which can be significantly lower than prevailing fixed rates. Even adjustable rate mortgages, which are similar in many respects, carry higher rates than balloon mortgages. However, interest rate increases are usually capped for ARMs, whereas balloon mortgages must be refinanced at the market rate. There are also closing costs associated with this refinancing, whereas ARMs carry any additional costs unless the borrower elects to refinance. Factor in prepayment penalties and extra mortgage payments, and it becomes a mystery why anyone would still be foolish enough to gamble with a balloon mortgage.