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Balloon payment mortgage

Explore the mechanics of balloon payment mortgages in this video, including how they work and in what situation a balloon payment loan might be advantageous and when it might work against you.

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Video transcript

So we already have some experience with traditional fixed-rate mortgages, but I'll give a little bit of a review before we talk about a little variation, or maybe we could say a big variation on it which is a balloon payment loan. So right over here, what I have depicted are the different payments you would make on a 30-year fixed mortgage. So this is a 30-year fixed mortgage where you have a fixed payment every month of $1432.00 and the loan amount is $300,000. So before you make your first payment you owe the bank $300,000 and you keep making these payments. And we've seen in previous videos that your very first payment, as you see in magenta here, is mostly interest. $1000 of that $1432.00 is interest. Then the next payment, you've paid down the principal a little bit, not a lot, about 400-something dollars. Now your next payment, $999.00 of it is interest. And the next payment, $997.00 is interest. And you keep doing that for all 360 payments. Remember, 30 years times 12 months per year, you would have 360 payments, and as you get to the end of your 30-year mortgage, most of your payment is principal. So on the 2 months before you pay it off, that 358th payment, only $14.00 is interest. Then the next one, 9 or 10 dollars is interest. Then, roughly $5 is interest and then you have paid off the entire loan. So you have a fixed payment, you also have a fixed interest rate. I haven't said what the interest rate is for this mortgage, but then you pay it off over 30 years, there's a 30-year amortization. And the word <i>amortization</i> means 'spreading out' something. So in this case you're spreading out the payments over 30 years. Why am I giving this as the preface to a balloon loan, a balloon payment mortgage? In a balloon payment, this was a little confusing to me the first time I learned about it, the term is different than the amortization. So, for example, you could have a 10-year-term balloon payment loan that still amortizes over 30 years. So what do I mean by that? Well, in this situation, your payments could be exactly the same, but then after 10 years, because it's a 10-year term, you have the loan for 10 years, after 10 years the loan is done for. So 10 years is 120 months, this is the 10 years here. After 10 years, you amortize it. Remember this payment schedule that we set up is based on a 30-year amortization, just as if we were doing a 30-year fixed rate mortgage. But in the balloon payment, if you had a 10-year term with a 30-year amortization, the payments are the same, but after the 10 years, at the end of the loan you don't just make that 120th payment, you have to pay back whatever the principal is, whatever is left on the loan. So we see that after 10 years, what's left on the loan is $236,352. In a balloon payment, the loan lasts for 10 years even though the amortization, the rate at which you're paying down the principal, is the same as for whatever the amortization schedule is, the 30-year amortization. So the question is; why does this thing exist? In some ways, this is like what we talked about in the adjustable rate mortgages. It's spreading the interest rate risk between the bank and the lender. In a 30-year fixed loan, all of the interest rate risk goes to the bank, while in an adjustable-rate mortgage, all of the interest rate risk goes to the borrower. Here the bank is guaranteed only to take on interest rate risk for 10 years, then after that they get the balance of the loan. What does the borrower do, or why would a borrower want to do this? They might want to do this because maybe they get a slightly lower interest rate than with a 30-year mortgage, while they get the exact same payments. They get a lower interest rate because the bank is taking on less interest rate risk, they have less risk if interest rates were to spike up 20 years from now. And a lot of people might say, "Well, I don't think I'm going to own this property for more than 10 years as long as I get a 10-year fixed payment, if I sell the property in the 9th year, then I just pay off the loan." Another possibility is that the person thinks they'll end up with a lot of cash, maybe they expect an inheritance, expect to earn more money. Another possibility, if none of that happens, if after the 10th year they say, "I still want to continue paying this house down, I don't plan on selling it, haven't come up with some windfall of cash to pay $236,000." Then they can just take out another loan to borrow the $236,000. And there's some risk involved there, because you have to feel good that at that time you'll still have a good credit history, you'll still have the level of income necessary to get another mortgage. So hopefully this gives you a sense of what a balloon payment mortgae is. It's not nearly as typical as a fixed-rate 30 year or a 15-year fixed or 10-year fixed, or as common as an adjustable ARM or a hybrid ARM, but they do exist so it's interesting to know about them.