A balloon payment mortgage is one where a large cash payment is due sometimes towards the end of the life of the loan. These can make sense in some financial circumstances, but are not for everyone.
Typically a balloon payment mortgage is structured for a shorter term
than a conventional 15 or 30 year fixed interest rate mortgage. These
typical are for 5 or 7 year terms where the payments each month are very
similar to that of a 30 year mortgage; however, there is a large
payment one has to make at the very end of the mortgage. The borrower
is responsible for coming up with the entire balance of the loan
principle at this time.
Generally speaking, most people will not be able to come up with the full amount of this final payment. Usually, at this point, people will attempt to come up with the payment by refinancing the balance with another mortgage. Sometimes the original loan will come with a provision that allows the borrower the ability to refinance the loan with the same lender. Agreeing to such an arrangement is not usually a good idea even though a person might feel that they can sleep better at night knowing that if they cannot come up with the payments that they have this option built into contract.
Generally speaking, the problem is that these contracts are adhesion
contracts written by the bank's attorneys. They will normally contain
all sorts of language allowing them to weasel out of the obligation to
finance the balloon payment; for example, if you were late on one
payment. At the same time, often attached to this clause are terms that
would not allow you to seek financing from another lender. At this
point, if the borrower violates any provisions of the fine print, then
they could really be taken advantage of by the lender who could almost
name his terms if they cannot come up with the payment by other means.
One the other hand, if one keeps the contract open such that one can chose to refinance with another lender, one can potentially get much better terms on the loan. You will hopefully have a solid period of five to seven years of successful payments which makes you attractive to other lenders who will compete for your business. You can then chose the best terms offered, which could be substantially better than the terms of the original loan, especially if interest rates have declined since when the loan was originated.
Due to the hassles of refinancing or the danger of running into a difficult credit environment when a balloon payment might become due, it is usually best for most people to avoid balloon payment mortgages. Where it really makes sense is for people who only expect to live in the house less than the term of the loan, since in such cases the house will usually be sold before the balloon payment comes due. For this reason it is ideal for people who move often or are in the business of flipping properties for short term profits.
Balloon payments are not ideal for everyone. Seriously consider how long you are going to stay in the house and what your potential refinancing options will be before entering in to such an agreement. If you are unable to handle the big payment at the end, it could be devastating to your financial well-being.