A balloon mortgage is a mortgage that does not fully amortize over the term of the mortgage and instead there is a balance owed at maturity. The final payment at maturity is called a balloon payment. The monthly payments are typically lower and might be interest only.
Pros:
Low or no monthly payment – While the interest rate may be higher, balloon mortgages often require interest only payments, which end up being a lower monthly payment since principal is not included in the monthly payment. Some balloon mortgages will not even require a monthly payment and instead require the full payment of interest and principal at the maturity date.
Option to defer payment – Ultimately, you will need to pay off the loan with interest at maturity, but you can avoid having to make monthly payments during the life of the loan if all interest is to be paid at the end of the loan.
No or less harsh prepayment penalty – A prepayment penalty is a penalty for paying off the loan before the maturity date. The term of a balloon mortgage is usually short, often just 1-3 years. Thus, balloon mortgages often do not include a prepayment penalty, or if it does include one, then it is less harsh than those included in a conventional mortgage.
Cons:
More risk – The entire balance of the mortgage is due at maturity, so you will need a plan to have the funds needed to pay off the mortgage. A lot can change in someone’s financial life over the years, and you might not be able to pay off the balloon mortgage at maturity. Or the real estate market might turn sour causing the property value to drop. If you are unable to pay off the balloon mortgage at maturity, then the lender can foreclose, you may end up in a position where you must refinance with an unfavorable interest rate, or you have to sell the property.
Higher interest rate – Because balloon mortgages come with a lot of risk for the lender, lenders often ask for a higher interest rate.
Difficulty refinancing – If you are not making monthly payments or your payments are very low, then you might not have enough equity in the property to refinance when the balloon mortgage matures. If your plan is to pay off the balloon mortgage by refinancing, then be careful about your equity since if you do not have any equity in the property, you might not be able to refinance.