Imagine a balloon – bright, colorful, and generally indicative of celebration. While this visual can bring a sense of joy or nostalgia to just about anyone, it’s important to consider that not all “balloons” carry this positive connotation. Take for example, a balloon payment on a loan. Instead of air or helium expanding and growing the balloon, it’s being inflated by mounting debt. Suddenly this balloon is all but celebratory.
What is a balloon mortgage?
Unlike a traditional mortgage where you make regular payments toward the principal limit and interest on the loan, a balloon mortgage is quite different. With a balloon mortgage, monthly payments typically cover the interest on the loan, but not the principal. As a result, the monthly payments you make are insufficient for completely paying off the loan balance. When the loan becomes due and payable, you are left with a large total balance to pay. This balance can “balloon” to tens of thousands of dollars.
When shopping for a loan or considering tapping into home equity, it’s important to get all the facts up front. While home equity lines of credit (HELOC) loans are among the most popular financial tools, they can be structured with a balloon payment at the end of the loan’s term. This happens when the HELOC is amortized over a longer period than the life of the loan.
How exactly do balloon payments work?
While some balloon mortgages come with 3- to 5-year terms, HELOCs generally come with a 10-year term. Either way, the monthly payments are structured similarly to if you were paying off a 25- or 30-year term loan. This makes for extremely low monthly payments which can seem appealing. However, what’s not always obvious is the balloon payment steadily growing in the background. Most balloon loans require one large sum to pay off the remaining balance at the end of the loan term.
For example, suppose you secured a HELOC to borrow $100,000 with a 10-year term at the current market rate of 7.25%. Your monthly payment would amount to $682.18, assuming it included both principal and interest. However, at the end of the loan term, you would owe a balloon payment of $86,991.88.1 That’s nearly 87% of the loan balance to be paid all at once – yikes!
Risk Factors to Consider
Naturally, the example above begs the question, “Can I afford to pay back this large lump sum?” And for anyone considering a balloon loan, it’s important to think about if and how you can make this balloon payment before signing the loan papers. But that’s not the only risk factor to consider. In order to protect yourself from a potentially devastating payment at the end of the loan, here are a few more factors to keep in mind.
Your Financial/Credit Situation
When contemplating a balloon mortgage, you’ll want to seriously consider what would happen should your financial situation change over the duration of the loan. If your financial situation worsens, you may find yourself lacking the funds to pay off the balloon payment at the end of the loan. What’s more, your credit health may subsequently worsen, making it difficult, if not nearly impossible, to refinance your balloon payment into another loan with a favorable interest rate. Many homeowners struggled with this same scenario after the 2008 financial crisis as they were not able to qualify for a loan large enough to cover their balloon payment. Unfortunately, if this happens to you, the consequences could have detrimental repercussions, including foreclosure or a short sale.
Your Retirement Plans
Balloon payments have the ability to stifle the retirement plans of both pre-retirees and retirees alike. For pre-retirees, a large balloon payment may present financial challenges and leave them short on funds. As a result, many end up dipping into their 401(k) funds which is generally not a wise idea. Not only does taking money out of your 401(k) reduce future gains, it also carries consequences should you leave or lose your job. In this situation, the money would need to be repaid very quickly. And, if you can’t repay in time, you’ll owe both taxes on the money taken out and a 10% penalty if you’re under the age of 59½.
For retirees adjusting to a limited or fixed income, a balloon payment could burn through a large chunk of their total retirement savings. And since the balloon payment is typically paid as a lump-sum, retirees without a “rainy day” fund or “safety net” could very quickly find themselves in financial trouble, like outliving their retirement savings.
“How can I avoid a balloon payment in the first place?”
If you’re considering a HELOC, it’s important to shop around and do your research on the loan. Not all HELOCs come with balloon features, so if the first few you look into have these features keep shopping around. There are also additional options for tapping into home equity that do not come with balloon payments such as Home Equity Conversion Mortgage (HECM) loans. You can compare HELOC vs HECM loans here.
What is a Home Equity Conversion Mortgage (HECM)?
A Home Equity Conversion Mortgage – also known as a reverse mortgage – is a loan designed specifically for homeowners ages 62 and older to convert a portion of their home equity into cash. Insured by the FHA since 1988, today’s reverse mortgage loans come with consumer safeguard measures, contrary to the misconceptions and bruised reputation of years ago. These measures include required mortgage counseling, non-recourse loan protection, a financial assessment, and safeguards for eligible non-borrowing spouses.
Unlike a traditional “forward” mortgage, where borrowers are required to begin repaying the loan right away, homeowners do not have to repay HECM funds until after the final borrower no longer lives in the home as their primary residence or becomes unable to meet the loan terms. Better yet, unlike a HELOC, with a reverse mortgage there are no monthly mortgage payments required.2 You can pay as little or as much as you want as often as you’d like. If you have an existing mortgage on your home the proceeds are first used to pay off that loan. In fact, many customers refinance from a HELOC to a reverse mortgage, once they’ve realized it’s a better choice in the long run.
At Longbridge Financial, we can help you use your hard-earned home equity to address the financial challenges that impact so many Americans who are in, or preparing for, retirement. Reverse mortgages are all we do and we’re committed to recommending the loan only after we’ve made certain the program is right for you. We’ll get to know you, your goals, your home, and your finances as we discuss your options. We will help you determine what reverse mortgage solution is right for you. Not all lenders make this commitment.
Don’t get swept up by balloon payments. See why over 1.2 million Americans have already made a reverse mortgage part of their retirement plan.3 To learn more, contact the Longbridge team today.