Although not as popular as they were before the mortgage crisis, a balloon mortgage is still an option for homebuyers. These loans can be tempting, since they tend to come with lower interest rates and monthly payments than traditional mortgage loans. However, there are some potentially deal-breaking points you need to think about before considering a balloon mortgage for your next home purchase.

What is a balloon mortgage?
A balloon mortgage refers to any mortgage that doesn't fully amortize over the loan term. The borrower will make payments over a set period of time (usually five or seven years), at the end of which the entire remaining loan balance will be due at once. As you can probably imagine, this final payment can be large, and that's why it is referred to as a "balloon payment."

A colorful hot air balloon in a blue sky.

Image source: Getty Images.

The monthly payments on balloon loans are usually calculated by amortizing the loan over a standard 30-year period, although other calculation methods are possible, such as "interest only." At the end of the loan, some balloon mortgages have a "reset" option, which will automatically recalculate the mortgage at the then-current interest rate. If no such option exists, it is assumed that the buyer plans to either sell or refinance the home before the end of the term.

How does a balloon mortgage compare with other mortgage types?
To illustrate how a balloon mortgage compares to other types of mortgages, let's consider a buyer who wants to borrow $200,000 to buy a home. Here's some of the details of the payments they could expect with a balloon mortgage as well as with 30- and 15-year fixed-rate home loans, as well as a 5/1 adjustable-rate mortgage.

Mortgage type Typical interest rate Initial monthly payment Total of monthly payments Remaining balance after loan term Total cost of loan
30-year fixed 3.87% $940 $338,400 $0 $338,400
15-year adjustable 3.08% $1,389 $250,020 $0 $250,020
5/1 adjustable (ARM) 2.98% $841 uncertain $0 uncertain
7-year balloon 3.00% $843 $70,812 $167,964 $238,776

It may be tempting...
As you can see, mortgages with a balloon payment tend to have lower interest rates, and therefore lower monthly payments than other types of mortgages-without the uncertainty of an adjustable interest rate. And because of this, borrowers may be able to qualify for higher loan amounts with a balloon mortgage than they otherwise would.

For these reasons, balloon mortgages could be a good option for people who are expecting their income to rise significantly over the coming years, or borrowers who could potentially have much better credit scores a few years from now. Balloon mortgages are also a common choice among homebuyers who are planning to sell their house before the loan term is up, as it will provide the lowest interest rate in the meantime.

But, there's a big risk to consider
In theory, a balloon mortgage sounds like a good idea for homebuyers in certain situations, but make sure you consider the refinancing risk associated with the loans.

Many homebuyers who obtain balloon mortgages do so with the intention of refinancing the mortgage into a more traditional term when the initial term runs out. However, there are several things that could get in the way of that happening:

  • Interest rates could rise significantly between now and then, making your monthly payments much higher after you refinance.
  • There is no guarantee that you'll still be a "qualified" homebuyer five or seven years down the road. Your income could potentially drop, or your credit could be worse than it is now. Either of these things could make refinancing tough, expensive, or impossible.
  • Finally, property values could plunge between now and then -- it's the reason so many balloon mortgage borrowers ended up in foreclosure a few years ago. If the initial term of your balloon mortgage runs out, and your home is worth less than you owe, no lender is going to refinance your mortgage.

The bottom line on balloon mortgages
Unless you know for a fact you'll be selling the house within the next few years, it's tough to justify a balloon mortgage. Sure, a balloon mortgage could be a great deal if interest rates stay low, home values continue to appreciate, and your income and credit don't drop, but those are pretty big "ifs" to gamble hundreds of thousands of dollars on.

Are you taking advantage of this once-in-a-lifetime tax break?

The Economist calls it "The Biggest Tax Break You've Never Heard of..." and those who take action now can take advantage of the decade-long benefits that this new tax law promises to real estate investors.

If you want to learn how this monumental tax benefit can work for you, check out our comprehensive tax guide where we cover this incredible tax break and the numerous other ways you can build and protect your wealth through real estate investing. Simply click here to get your free copy today.

The Motley Fool has a disclosure policy.