A balloon mortgage is a useful financial tool that can create high value for homeowners if used correctly. If used incorrectly, however, a balloon mortgage can be harmful and can put unnecessary financial strain on a borrower. Risk of foreclosure increases when certain factors are present. Avoid a balloon mortgage in any of the following five situations.
Bad credit history. When a balloon payment comes due after the initial term of the loan, you are required to either pay the full remaining amount or refinance your home loan. Most homeowners choose to refinance. If you have a poor credit score, you may be unable to refinance and may find yourself facing a massive loan payment that you can't afford. At this point, foreclosure is likely.
Low or decreasing property value. A property with an especially low or decreasing property value may be difficult to finance. When the balloon payment comes dues and a refinance is necessary, you may be unable to secure a new loan. A balloon mortgage is not the best choice for an extremely low-end property.
No money down. Don't use a balloon mortgage to finance a house without making a down payment of some kind. The down payment gains you a significant share of equity in the home, which makes it easier to refinance when the initial term of the loan is due.
Interest-only terms. The homeowner doesn't build up equity ownership when making interest-only payments, as none of the principal balance of the loan is being paid for. Once again, this will make the upcoming refinance much more difficult. Also, monthly interest-only payments are typically lower than standard monthly mortgage payments, which may reflect poorly on the homeowner's financial flexibility.
Short initial loan period. Balloon mortgages allow the borrower to put off the bulk of the home costs until a later date when he or she will be able to either pay in full or refinance on better terms. But if the initial amortized loan period of the balloon mortgage is too short, the borrower won't have time to correct the problems that forced them into a balloon mortgage in the first place. Issues such as poor credit, legal battles, and low personal savings take time to address. Don't enter a balloon mortgage unless the initial loan period is long enough to allow for resolution of these issues.
