The balloon loan gets its name from the large payment that one can make to pay-off the loan completely. Though the balloon mortgage loan, in itself, is not very commonly used as other common mortgage loans, the clause of 'balloon mortgage payment' is often included in the loan contract of common mortgage loans. Now we need to understand the concept of balloon loan in two phases, one, how the mortgage loans conventionally work and two, how the balloon loan works. Apart from that, the balloon payment clause has also been discussed.
Theory and Facts about Mortgage Loans
The mortgage loans have been an issue of much debate and discussion in the recent past and so have been financial institutes which were involved in the lending of such loans. These very loans are in fact, quite hated by several people owing to the fact that they had a more than fair share in the sub-prime lending and the sub-prime crisis.
A balloon mortgage is chiefly a variant of the common or simple mortgage loans, the ones which we know very well. The mechanism of balloon loans is based upon that of the common mortgage loans, and hence, we need to understand the basics of mortgages.
- A mortgage loan is a secured loan which is disbursed by the lender to the borrower in order to purchase a home, property or any real estate. The loan has a principal amount which is disbursed to the borrower and is usually a bit lower than the purchase price of the real estate. The real estate is pledged as a collateral or security with the lender.
- A standard mortgage loan amortizes (debt reduction after every payment), that is, this loan is repaid in equal parts to the lender and a Percent Per Annum (P.C.P.A), is charged to every installment paid. The decreasing debt is commonly referred to as the amortization of the loan amount. An installment chiefly is made up of amortized debt or principal amount plus the interest, which is charged according to the rate of interest or rather the P.C.P.A.
- Conventionally, a mortgage loan's debt or principal amount amortizes in 10, 15 or 30 years, depending upon the volume of initial principal amount and amount of every individual installment.
- The equal parts which are amortized are the reason why a mortgage is a good debt and borrowing instrument. The interest rate remains applicable throughout the repayment, even if the repayment overshoots the stipulated 'last date' or the maturity, indicating the end of the term of the loan. The interest rate becomes inapplicable, once the amortized installments have been made in complete.
- Now it must be noted that the interest rate can be both fixed or variable. The variable ones sometimes tend to pose a hassle. The interest rate, whether fixed or variable is usually computed on the basis of your credit score. Thus, the rule of thumb goes that better your score, lesser is your interest rate. Another fact one should note is that in the post-recession era, lenders consider borrower with more than 600-650 score for a mortgage loan.
This was the basic working or mechanism of the mortgage loans. Now there are several other variants of this kind of loan, a balloon loan is one such variant.
How Does a Balloon Mortgage Work?
The balloon mortgage as mentioned above is a variant of common mortgage loans such as 10, 15 or 30 year fixed rate mortgages, or rather a simple mortgage. In fact, often in the common mortgages, a balloon clause is included. Let's take a look at this variant:
- As mentioned above, conventionally a balloon mortgage works just like the common mortgage. However, the difference lies in the amortization of the debt/principal amount. The balloon mortgage has a series of regular installment payments for a first few years following which the borrower returns the entire remaining money in one go. The huge amount thus repaid, has earned the payment nickname, 'balloon payment', which gives the loan its name.
- This balloon payment mortgage usually starts off as a regular 10,15 or 30 year mortgage. Following this, the borrower has an option of continuing it as a regular loan or has the option of paying off the entire debt in one shot.
- Now as per the Truth-in-Lending legal provisions, the amount that can be included in the balloon payment, the number of years or installments after which the payments can be made, can be specified and enforced in the agreement of the loan.
- In some cases, the borrowers often quickly repay the balloon mortgage with the help of a refinancing mortgage loan and then take the advantage of the lower interest rate of the refinancing loan.
- In some cases, a mere mention of the balloon mortgage payment clause is made. However, often loan in itself is a balloon mortgage loan.
- Apart from the aforementioned facts, the balloon payment can take place in one or two payments. There's no hard and fast rule that it has to be done in one single go.
Now it is obvious and evident that the balloon mortgage has several merits and in fact, having a balloon mortgage or even just including the related clause in the agreement with the mortgage company gives you an opportunity to strike off your liability fast and you also end up paying lesser interest.