Finance

Balloon Mortgage vs. Interest-Only Loan: What’s the Difference?

One of the hallmarks of the 1990s housing boom was the balloon mortgage. It was a risky type of mortgage that helped people who could otherwise not afford to buy homes get a foot into the housing market. Balloon mortgages are not nearly as popular as they once were. Incidentally, they are sometimes confused with interest-only loans.

Although a balloon mortgage can be structured as an interest-only loan, it doesn’t have to be. Lenders and financial experts consider the two types of loans distinct and different. Let us take a look in more detail, beginning with the interest-only loan.

Basics of the Interest-Only Loan

An interest-only loan is structured so that monthly payments cover only the interest. The principal is not paid until the final payment on the loan’s maturity date. Interest-only loans are attractive because of their low monthly payments. But they can also be risky. More on that in a minute.

Note that interest-only loans can be offered for any number of reasons. Salt Lake City’s Actium Partners might structure a hard money loan as interest-only financing intended to help a real estate investor acquire a new property. Meanwhile, a traditional Salt Lake City bank might offer an interest-only loan to a local business looking to expand.

It is entirely possible to get interest-only mortgages as well. In such a case, the basics remain the same. Monthly payments account only for interest. The principal is not paid until loan maturity.

Basics of the Balloon Mortgage

A balloon mortgage is a type of loan intended for residential real estate transactions. Moreover, nearly all balloon mortgages go to people purchasing the homes they will live in. Like an interest-only loan, a balloon mortgage is attractive because of its monthly payment structure.

Balloon mortgages can be structured in one of three ways:

  • No Monthly Payment – Believe it or not, some balloon mortgages require no monthly payments at all. The only requirement is a single balloon payment covering both interest and principal at maturity.
  • Interest-Only Payments – A second option for loan structuring requires interest-only monthly payments. This sort of arrangement is identical to the previously explained interest-only loan.
  • Low Monthly Payments –The third loan structure involves monthly payments that cover interest and a small portion of the principal. They are intentionally kept low to make them affordable.

All three types of loans have one thing in common: a balloon payment at the end. Hence the name. If you were to borrow $200,000 on a balloon mortgage to buy a new home, you would have to find a way to make sure it was paid in full on the loan’s maturity date.

Benefits and Risks

Interest-only loans and balloon mortgages come with both benefits and risks. The benefits are all linked to low or no monthly payments. By keeping monthly payments to a minimum, borrowers have opportunities to put their cash toward other things. While this may be ideal for a property investor, it is generally not smart for someone looking to purchase a primary residence.

The biggest risk is not having the money to pay off one’s loan at maturity. This was a big problem with the 1990s balloon mortgages. People who could not afford to make monthly payments were still buying homes. Unfortunately, they were no more prepared to make their balloon payments when due.

Although there is some overlap between balloon mortgages and interest-only loans, they are considered distinctly different loan instruments. Now you know the basics of both. Should you ever consider either type of loan, make sure you know what you are doing before you sign on the dotted line.

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