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How Will Making a Balloon Payment Affect the Interest on a Loan?

written by: Mariam Anthony•edited by: Jason C. Chavis•updated: 12/27/2010

What is a balloon payment loan and how does a balloon payment affect the interest on your loan? A balloon payment loan allows a borrower to borrow at a fixed interest rate for an initial period. After the initial period he will have to close the loan either by refinancing or by paying in full.

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    A balloon payment loan is a type of loan which does not amortize over the term of the loan, thus leaving a balance on the loan that has to be be paid back at maturity. If you are a borrower with a balloon payment loan and find that you do not have the liquid funds to repay the loan at maturity, you may have to refinance the loan. So exactly how does a balloon payment affect the interest on your loan? A balloon payment will force you to refinance at the current interest rates, which may (or may not) be higher than the previous interest rate.

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    What is a Balloon Payment Loan?

    In a balloon payment loan, the loan amount is not fully repaid during the tenure of the loan and the outstanding amount is repaid at the end of the note period. A balloon payment mortgage is one of the many types of mortgages in the mortgage industry, there are fixed rate mortgages, adjustable rate mortgages, interest-only loans and so on. Each type of loan is targeted to a specific type of borrower.Balloon Payment Loan 
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    Borrowers generally opt for a balloon payment loan either with the intention of selling the collateral security at the end of the initial contractual period or with the aim to refinance. For example a person may only plan to stay in his home for five years after which he may want to sell it. In that case he can go for the balloon payment mortgage and close the loan when it is due for the balloon payment.
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    How Does a Balloon Payment Loan Differ from an FRM?

    A balloon payment mortgage acts like an FRM during the initial period, but after that the borrower need to make the balloon payment and close the loan. Unlike an FRM which allow a borrower to enjoy the same interest rate for a fifteen year or thirty year term, a balloon payment mortgage forces a borrower to refinance at the existing interest rates after the initial period. The interest rate on a balloon payment mortgage is typically lower than that of an FRM because of this additional refinancing risk.
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    How Does a Balloon Payment Loan Differ from an ARM?

    In an adjustable rate mortgage, the interest rate fluctuates in line with a chosen index. A balloon payment loan is similar to a Hybrid ARM, which is a type of ARM with a fixed interest rate for an initial period and a variable interest rate for the rest of the term. The difference between the two is that after the initial period a Hybrid ARM exposes a borrower to interest rate risk (the risk that interest rates may go up in future) while a balloon payment loan has refinancing risk, the risk that interest rates may be higher at the time of refinancing. The borrower will also have to bear the additional expenses related to refinancing such as closing costs.

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    In the end, do you really need a balloon payment loan? Not all borrowers benefit from a balloon payment mortgage. There are a lot of questions that you must ask yourself before going for a balloon payment loan. How does a balloon payment affect the interest on your loan? Are you at least ninety percent sure that you will sell your house before the balloon payment is due and if not, are you convinced that you can refinance at favorable rates? If the answer to these questions is a 'no', you may be better off with another type of mortgage.

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    References

    1. U.S Dept of Housing and Urban Development Website, www.hud.gov/buying/loans.cfm.
    2. The Mortgage Professor website, http://www.mtgprofessor.com/A%20-%20Balloon%20Loans/is_a_balloon_loan_better_than_an_arm.htm

    Image Credit: Medmoiselle T; http://www.flickr.com/photos/75511860@N00/3006398531/