Buying a home is one of the most expensive purchases you can make. Thankfully, there are ways to save on mortgages. But some of those ways can turn out to be costly.
If you’re trying to buy a home but can’t make payments, you might choose a balloon payment to help offset the costs. But what is a balloon payment? It might not be a great choice, depending on your financial situation. Here’s what it is and how it can help (or hurt) you.
What is a balloon payment?
A balloon payment is a large amount due at the end of a loan term. It’s usually — but not always — at least two times your loan’s average monthly payment.
You’re obligated to pay the balance at the end of the term, regardless of how much that payment might be.
Balloon loans are most common with mortgages but are also available for auto loans and other types of debt. But the Consumer Financial Protection Bureau notes that balloon payments aren’t allowed in qualified mortgages, which are mortgages where lenders meet certain requirements to make the loans less risky.
Balloon payments aren’t as common anymore because of the Dodd-Frank Act, which became law in 2010. Mortgage reforms were implemented to help consumers and protect them from shady lending practices.
Through Dodd-Frank, borrowers with high-cost loans are entitled to ways to lower their interest rates. Lenders can no longer pressure borrowers into agreeing to costlier loans.
What is a balloon payment good for?
If you’re looking for low monthly payments but want to finish a loan faster than the original terms state, you’d opt for a balloon loan. Corey Vandenberg, a mortgage consultant in Lafayette, Indiana, said there are some benefits to making a balloon payment.
“If you know you are going to sell a home, there may be a good reason to have a balloon,” he said. “Any windfall coming, like inheritance, sale of investments, [or] retirement bonus, could be a good reason for a balloon payment.”
The thinking is that if you aren’t able to make big monthly payments now but you’re expecting a large sum of money later to make that final balloon payment, it’s not such a bad idea.
If you’re hoping to buy a home but don’t have a hefty down payment, you’re showing lenders you don’t have a lot of equity. A large down payment can get you lower monthly payments and a lower interest rate, but it also proves to lenders that you’re financially responsible.
But not everyone has the cash on hand for a large down payment, so you might instead opt for a balloon payment. You’ll make low monthly payments until the end of the loan, at which time you’ll pay the remaining balance in one lump sum.
What if you can’t afford a balloon payment?
Even though balloon payments aren’t used as much, Vandenberg said many small lenders are still using these types of loans.
There might be a chance that you won’t be able to afford that balloon payment at the end of your loan term. Sometimes these payments can be hundreds of thousands of dollars, according to Investopedia.
If you can’t make the payment, you would want to look into refinancing your loan before the balloon payment is due. Refinancing will convert your balloon loan into a traditional loan.
While this is a good way to avoid a balloon payment, Vandenberg said lenders don’t need to help you by offering a better interest rate or more reasonable terms.
“The lender is not under obligation to switch, that is the danger,” he said. “You have to find a lender who will accept you in present condition.”
Balloon payment alternatives
If you can’t imagine one big payment at the end of your term, you have options for other types of loans. Vandenberg suggested other ways to get a lower monthly payment, such as securing fixed-rate interest instead of variable interest and getting a 30-year term.
If you can’t find alternatives to a balloon loan, start thinking about saving money every week or month to put toward that final payment. Also, if you’re stuck in a balloon loan, do your best to refinance it to a traditional loan when your terms are almost up.
It’s easy to think that one large lump sum is very bad for your finances, but remember how you got there. A balloon payment allows you to have lower monthly payments until your loan’s term is up. It’s meant to ensure you’re able to make payments on time and in full. But if you can’t afford that final balloon payment, you might want to reconsider your loan.
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