What is a Balloon Payment?
A balloon payment is a payment that covers the balance of a loan at the end of a loan term. It's usually much larger than the earlier payments on the loan.
Balloon Payments and Real Estate
As it applies to home financing, a balloon mortgage doesn't fully amortize over the period of a loan. So instead of paying on a mortgage over 30 years, a homeowner would make payments for only five or seven years, and then they'd be required to pay the balance with a a large (balloon) payment.
As long as borrowers understand the risk and are willing to subsidize a balloon payment out-of-pocket, without pinning hopes on appreciation, a balloon payment loan could work. (An example: You're receiving an inheritance that takes time to work through probate.) Otherwise, these types of real estate loans can be very risky.
The History of Balloon Payments
In the 1970s, it was common to see balloon payment language as part of real estate financing. To provide cash flow or a breakeven point for the real estate investor, it was not unusual to take title subject to the existing loan and give the seller a second mortgage without any payments. This was known as a straight note.
As long as the second mortgage was small, maybe less than 10% of the purchase price, not making any payments on the loan was one way to generate cash flow. An investor could receive a positive cash flow this way because the existing mortgage payment, plus the insurance and taxes, were generally low enough that the investor could see some sort of return from the rental payment after the expenses were paid. This practice presumed that the property would appreciate over the term of that second mortgage, which was generally three years.
The reason this worked so well in the late 1970s was that 90% of the property value was appreciating, while only 10% of the value was defrayed. So a $100,000 home, in practice, could be worth $133,100 at 10% appreciation after 3 years, which was more than enough to pay off a $10,000 promissory note at 10% interest, even with compounded interest.
The Inherent Risk of Balloon Payments
What happens if there is no appreciation—or worse—the market falls? That's how some homeowners in 2007 got into hot water due to dealing with subprime mortgage lenders. One of the popular financing options then were Option ARM mortgages, which contain interest-only payment options coupled with a balloon payment.
A homeowner during those years might buy a home with no money down, take out an 80/20 combo loan, and both loans could be due and payable with a balloon payment at the end of five or seven years. In declining markets, it made it impossible to sell a home and pay off the loans without resorting to a short sale. Another option was to walk away from the home.
None of those options were things the borrowers thought about when they bought the home. They believed the hype that real estate values would always rise. Instead, they ended up owing more than the home was worth and could not meet the balloon payment obligation.