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Wednesday, August 23, 2006

Basic Terminology: Balloon Mortgage

One popular type of mortgage product is the Balloon. A balloon mortgage has two numbers associated with it: the balloon term and the loan term. The main idea of a balloon product is that you make payments as if the loan were spread across the entire balloon term, but at the end of the loan term the entire remaining balance is due. A typical sub-prime balloon product would be a 40/30 balloon. The 40 is the balloon term, and the 30 is the loan term.

The advantage of the balloon is that you make a lower payment throughout the balloon term, while the disadvantage is that there is a large balloon payment at the end of the loan. This can be a huge weight hanging over your head for years.

Many lenders that have a huge portfolio of interest only loans are now steering borrowers towards long balloon term products such as the 40/30. The borrower gets the benefit of the lowered payment and can qualify for a higher loan amount, while the lender takes less risk since some equity is being built with every payment. Interest only products don't generate any equity except for the appreciation of the property, and if the property value falls the borrower can easily owe more than the house is worth.

The balloon product can be either fixed rate or adjustable rate. Products such as a 5 year ARM with a 40/30 balloon are now common. This gives the borrower the benefit of both the lower payment of an ARM for the first 5 years plus the lower payment of the balloon. This type of product can be used to leverage a much larger loan amount, but carries double risk. After a few years the adjustable rate can make the payment jump and there is always the balloon payment to be saving towards.

Balloon loans can be a good option for many borrowers, but realize that at the end of the balloon term the loan must either be paid in full or refinanced at the current rates, which could be much higher than when the loan was originated.

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