Balloon Mortgage Versus an Adjustable Rate Mortgage

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Balloon mortgages and adjustable rate mortgages (ARMs) are comparable, but with important differences.

What Is a Balloon Mortgage?

A balloon payment mortgage is a short-term loan, usually with a term of five, seven, sometimes ten years, but with monthly payments that are calculated based on a term of 30 years. Balloon loans may carry lower interest rates and are even sometimes easier to qualify for than 30-year loans. Sound great? Here's the balloon part of the loan: After the five, seven, or ten year term, the outstanding balance must be repaid in full. You must refinance the mortgage, sell the property, or convert the balloon mortgage to a more traditional mortgage at current interest rates - or, in theory, you could write a check pay off the loan.

Hitting the Reset Button

Naturally most borrowers do not have the resources to make the balloon payment at the end of the term, and completely pay off the loan. Refinancing the ballon mortgage at the end of its short term at current rates is a common choice. This refinancing action is sometimes called a reset option or two-step mortgage plan.

The option of resetting the loan is usually only available if you are still the owner/occupant, you have no 30-day late payments in the preceding 12 months, and you have no other liens against the property. If a reset option is not available, you must sell the property or refinance the loan.

Sounds Like an Adjustable Rate Mortgage

Balloon mortgages and adjustable rate mortgages (ARMs) are comparable. Both have an initial rate period, where at the end of that term, the rate will be adjusted. Beyond that similarity, though, each type of loan has important distinctions.

New Rate at the End of the Initial Term - At the end of the initial term, the borrower with a balloon mortgage usually pays it off with a new loan that carries the current market rate. At the end of the initial term, the borrower with an ARM, on the other hand, has to comply with the conditions outlined in the loan contract - however complicated.

Rate Difference - Lenders usually offer a lower rate for balloon loans because that rate will be predictably adjusted to the market rate at the end of the initial term. Lenders providing ARMs may be limited by interest rate caps when the time comes to adjust the loan, and therefore are likely to charge a higher rate for the initial period of the loan.

Speaking of Interest Rate Caps - Those very same caps on the new interest rate offered at the end of an ARM's initial term that make the ARM more expensive also protect you from spikes in future interest rates. These kinds of interest rate jumps are rare, but occasionally happen. A balloon loan adjusts to the prevailing interest rates no matter how harsh. ARMs have caps to limit the adjustment rate hike.

The same interest rate protection an ARM offers holds true if your personal credit rating slips. The ARM contract is set with interest rate limits determined at the beginning of the term of the loan. Lenders of balloon loans have no specific refinancing obligations, and will include your credit rating as part of the calculation of the new adjusted interest rate - even if you only had a single late payment in the previous 12 months.

Refinancing Costs - Borrowers of balloon loans incur refinancing costs at the end of the intiial term. Borrowers of ARMs pay refinancing costs only if the new rate is lower than the rate of the initial term.

Seeing into the Future

Notoriously hard to do. Balloon mortgages and adjustable rate mortgages are designed to save you money in the relatively short term. If you strongly believe you that will be out of the property before the end of the initial period, a balloon mortgage or even an ARM might be the right loan for you. If there's a pretty good chance that you might still occupy the home beyond the short term, a fixed rate mortgage is probably a better bet.

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