What is a Balloon Loan?
What is a balloon loan? Before you can understand balloon loans, you need to have a grasp on loan amortization. Loan amortization refers to the process of repaying a debt by making periodic installment payments until the loan term is completed or you sell or refinance, whichever comes first. Speaking of firsts, be advised that first mortgages are almost always fully amortized. That’s lender jargon to describe a loan that will be completely repaid after you make the final, regularly scheduled, monthly mortgage payment.
Some second mortgages are also fully amortized. However, some second mortgages come due long before they’re anywhere near to being fully repaid. Any mortgage that comes due with an unpaid balance is known as a balloon loan. Others may be home equity interest-only loans for, say, 10 years and then fully amortize over the remaining 20 years. Thus, they will have a big jump in payment after ten years.
The final monthly installment that pays off a loan’s entire remaining principal balance due is called a balloon payment. Balloon payments generally resemble blimps.
Because balloons bring to mind images of birthday parties and light-hearted frivolity, it seems somewhat misleading to name these mortgages after something so benign. They’re more aptly referred to as bullet loans by lenders who’ve seen balloon loans mutate into financial bullets blasting hapless borrowers who can’t repay or refinance their mortgages when they come due.
We don’t want to scare you away from balloon loans. They can be used to augment your cash for a down payment, reduce your interest charges, or pull equity out of your present house to buy your next home. They’re useful financial resources when used properly.
80-10-10 financing for balloon loans
Surprising as it may seem, some folks with hefty incomes find that it’s mighty tough for them to save enough money to make a 20 percent cash down payment on their dream homes. Buyers using conventional financing who can’t afford to put 20 percent cash down must purchase private mortgage insurance (PMI). Buying PMI increases the cost of home ownership and, ironically, makes it even more difficult to qualify for a mortgage.
Good news: You’re about to discover how you may be able to circumvent those nasty PMI costs with 80-10-10 financing.
Even if you put 20 percent down, you could still end up paying a higher interest rate on your home loan if you get a jumbo first mortgage. These mortgages exceed the Fannie Mae and Freddie Mac conforming loan limits.
Using 80-10-10 financing to avoid PMI
If you’re a dues-paying member of the cash-challenged class, don’t despair. Given that your income is sufficiently high, it’s eminently possible to avoid getting stuck with PMI. That’s why 80-10-10 financing was invented. It’s called 80-10-10 because a savings and loan association, bank, credit union, or other institutional lender provides a traditional 80 percent first mortgage, you get a 10 percent second mortgage, and make a cash down payment equal to 10 percent of the home’s purchase price.
Where do you obtain the 10 percent second mortgage? The most common sources are
- House sellers: Some sellers offer qualified buyers attractive secondary financing either as a sales inducement or because they want to generate income from the loan. Owner-carry second mortgages are generally less expensive than seconds made by institutional lenders such as banks and credit unions because most sellers don’t charge loan origination fees — and sellers usually offer lower mortgage interest rates to boot. Seller seconds are nearly always short-term balloon loans due and payable three to five years after origination.
The institutional lender that holds the first mortgage will most likely insist upon reviewing the terms and conditions of the owner-carry second mortgage. For one thing, the lender needs to be sure you can afford to make monthly loan payments on the first mortgage plus the second without overextending yourself. The lender will also probably insist upon at least a five-year term for the second mortgage, so you’ll have plenty of time to save up for the balloon payment when the second comes due.
Five years will also usually allow for home appreciation to create homeowner equity that can be tapped through a HELOC loan to repay the second mortgage, or you can refinance all your debt into a single new loan.
- Institutional lenders: Yes, the same friendly folks who originate your 80 percent first mortgage may also provide secondary financing. This type of loan program varies from lender to lender. Some lenders structure the second as a home equity loan; others offer a conventional second mortgage. The secondary financing may or may not be in the form of a balloon loan. If the second is fully amortized, it’s usually structured as a 15-year mortgage.
Don’t get hung up on terminology. Just because this type of financing is referred to as 80-10-10 doesn’t mean you absolutely, categorically must put down 10 percent cash. The same principle applies if you can afford to make only a 5 percent down payment — 80-15-5 financing may be available. Because a smaller cash down payment increases the lender’s risk of default, however, don’t be surprised when you’re asked to pay higher loan fees and a higher mortgage interest rate for 80-15-5 financing and 80-10-10 financing versus traditional financing where you make a 20 percent down payment.
Playing with the numbers
Now we’re going to crunch some numbers so you can see with your own eyes 80-10-10 financing. Each of the following examples assumes the same three conditions — that the home you’re buying costs $200,000, that you’re making a 10 percent ($20,000) cash down payment, and that you’re a creditworthy buyer:
- PMI: In this scenario, you don’t know about 80-10-10 financing. You foolishly get a $180,000 (90 percent of purchase price), 30-year fixed-rate first mortgage with an 8 percent interest rate. Your monthly loan payment is $1,322. PMI costs an additional non-tax-deductible $78 per month (check the current rules). You pay $1,400 per month in total loan charges.
- Owner-carry second mortgage: You diligently search until you discover a seller who’ll carry a $20,000 fixed-rate second mortgage amortized on a 30-year basis. The loan, however, is due in five years. You negotiate a 7.5 percent interest rate; your payment is $140 per month. With 10 percent down and a 10 percent second, you need only a $160,000 (80 percent) 30-year fixed-rate first mortgage at 8 percent interest costing $1,175 per month. Total loan charges are $1,315 a month, $85 less per month than the PMI example — and all the interest you pay on both mortgages is tax deductible. The final advantage is that you can pay off the owner-carry second mortgage any time you want. PMI, conversely, is harder to get rid of than head lice. You’re so smart.
Not so fast, smarty. Don’t forget that the second mortgage is a balloon loan. It’s due and payable in payable in five short years. You’ll be dismayed to discover that 94.6 percent of your original $20,000 loan remains to be paid five years after the loan is originated. In other words, your loan balance is $18,920 even after paying the seller $8,400 (60 monthly payments of $140) over five years. What if you can’t refinance the second mortgage when it’s due because you lose your job? Or what if property values drop and the appraisal comes in too low to pay off the second? Or what if interest rates skyrocket and you can’t qualify for a new loan at the high mortgage rates? Now maybe you understand why they’re called bullet loans.
- Institutional lender second mortgage: In this example, the seller of your dream home won’t carry a second. You wisely opt for 80-10-10 financing from a bank. You get a $160,000 (80 percent) 30-year fixed-rate first mortgage at 8 percent interest costing $1,175 per month. The bank offers you a choice for your $20,000 second — either a fixed-rate mortgage (FRM) amortized over 30 years but due in 15 or a fully amortized, fixed-rate, 15-year loan. You’d pay $191 per month for the 30-year, FRM balloon loan with an 11 percent interest rate versus $225 a month for the 15-year FRM at 10.75 percent interest. What to do? What to do?
What an interesting choice. You’d pay $1,366 per month for an 80-10-10 that has a $16,760 balloon payment due in 15 years. Taking the fully amortized second mortgage increases your monthly payment $34 to a nice round $1,400 . On the plus side, you’d build up equity faster with that second mortgage, and there’s no balloon payment to fret about. (If that kind of fiscal pressure debilitates you, either of the bank’s second mortgages are preferable to the owner-carry second with its five-year due date.)
Truth be known, it’s highly unlikely you’d keep either of the second mortgages for 15 years. Given their high interest rate, you’d wisely refinance the one you select as soon as possible or pay it off when you sell your house and move into a magnificent mansion.
Given those assumptions, we’d advise taking the balloon second mortgage and investing the $34 a month you save in a good mutual fund. If the thought of balloon payments causes you to lose shuteye, however, you have our permission to take the fully amortized second. The choice is yours.
Shrinking jumbo can slash your interest rate
Congress sets upper limits on mortgages Fannie Mae and Freddie Mac purchase from institutional lenders for resale to private investors. These loan limits are adjusted annually to ensure that they accurately reflect changes in the U.S. national average home price. For example, the maximum single-family dwelling loan Fannie Mae and Freddie Mac could buy at the beginning of 2018 was printed was $636,150. That amount may have changed by now, so be sure to check with your lender to determine the present loan limit for the type of property you intend to purchase.
Mortgages that neatly fall within the current Fannie Mae and Freddie Mac loan limits are called conforming loans. Conventional mortgages over the maximum permissible loan amounts are referred to as jumbo conforming or true jumbo loans. This is a critically important financial distinction if your mortgage happens to exceed the conforming loan limit. Interest rates on jumbo conforming or true jumbo fixed-rate mortgages are normally 1/2 to 1 1/2 percent higher than their conforming fixed-rate brethren.
Why pay one red cent more than you have to for your home loan? If the amount of money you need to borrow is slightly over the Fannie Mae and Freddie Mac current conforming loan limit, use the 80-10-10 financing technique to cut that costly jumbo loan down to size.