When you are considering home loan options, you may come across something called a lump sum payment. A lump sum payment is often tied to a lump sum loan, which may have lower upfront payments than a traditional loan, but can also increase your risk as a borrower.
Before accepting a loan with a lump sum payment, make sure you know the risks and understand your options when the loan is due.
What is a lump sum payment?
Most lump sum loans require a lump sum payment, a large lump sum due at the end of the term to pay off the balance. This final amount is often more than twice the average monthly loan payment.
Monthly payments are usually lower for a balloon loan compared to a traditional 30-year mortgage because the lender accepts the interest rate risk for, say, 10 years instead of 30, says Evan Swanson, mortgage advisor at Cherry Creek Mortgage.
“In other words, from the lender’s point of view, their loan amount is guaranteed to be paid back within 10 years,” Swanson said. “Assuming interest rates rise over the initial 10-year period, then lenders are able to loan the money again for a higher interest rate.”
From the borrower’s perspective, the tradeoff for lower monthly payments may be the substantial lump sum payment. Swanson gives the example of a $ 100,000 30-year loan with an interest rate of 3.5% compared to a 10-year balloon mortgage.
“The borrower’s monthly payment is based on the amount needed to repay the loan over a period of 30 years”, in this case $ 449.04, he says.
You will make the same monthly payment with the balloon loan, but you will owe a balloon payment of almost $ 78,000 unless you refinance after 10 years.
Note that lump sum payments are not allowed for most qualifying mortgages, which may not include certain subprime loan features.
How is a balloon loan different from other home loans?
The main difference between a balloon loan and other home loans is that the former leaves the borrower with a principal balance at the end of the term and the latter is paid off entirely through amortization. The amortization process spreads out the principal and interest over time to pay off the debt.
Another difference is that a balloon mortgage has a much shorter term of five to 10 years compared to 30 years for a traditional mortgage.
“If you have a seven-year balloon, you’ll get a monthly payment based on 15 or 30-year amortization,” says Carolyn Morganbesser, senior director of mortgage origination at Affinity Federal Credit Union. “But after seven years your loan is due.”
You might only pay interest each month or part of the interest and principal, but in all cases, you will owe a lump sum at the end of a balloon loan.
What are the advantages and disadvantages of a balloon loan?
- Interest rate. Balloon loans can have lower interest rates than standard fixed rate loans because balloon loans have to be repaid faster, which means they can be less risky for lenders.
- Monthly installments. Paying little or no principal results in a low monthly payment until the lump sum payment is due.
- Amount of the loan. A balloon loan can allow you to buy more home or move into a home sooner than you would otherwise.
- Large final payment. It can amount to tens of thousands of dollars.
- Risk. If you can’t make the lump sum payment, refinance, or sell the house, you could lose the property to foreclosure and damage your credit.
- Low equity. You will accumulate little or no equity in your home if your monthly payments are mostly or all interest, and refinancing could be difficult.
How to qualify for a balloon loan?
If your income or credit is lacking, a balloon loan may not be for you. This high-risk loan requires a excellent credit rating, a large down payment and a substantial income.
Overall, the process of qualifying for a balloon loan is similar to the process for a traditional loan. The lender will ask for proof of income and verify your debt to income ratio and credit to determine your ability to repay the loan.
“To apply for a balloon loan, you have to apply for one of the mentioned mortgages in essentially the same way,” says Lamar Brabham, CEO and founder of Noel Taylor Agency, a financial services company in North Myrtle Beach, South Carolina. .
How do I calculate my balloon loan payment?
The easiest way to calculate your lump sum payment is to use a free online lump sum payment calculator from one of the many banking websites.
Calculators typically require the price of the house, the down payment amount, the loan term, and the interest rate to calculate your monthly payment and lump sum payment.
How can I repay a balloon loan?
Ultimately, you need the money to make the final payment for the ball. You have three options: save, sell, or refinance. Whichever you choose, make sure you have a repayment plan before you apply for a balloon loan.
To safeguard: If you can, save enough money to pay off the loan balance when it falls due. It is best if you earn a substantial income or if you anticipate an increase in income before you make the payment.
To sell: Often a home will be sold before the lump sum payment is due, and the proceeds can be used to pay off the loan.
Refinancing: If you want to keep your property, you can refinance the balloon loan by using the proceeds from a second loan to make the balloon payment. It’s the most common practice for borrowers who don’t want to sell, Brabham says.
Should I get a balloon loan?
- You have enough money to cover the lump sum payment or are sure to receive a lump sum, such as a bonus or an inheritance, before it is due.
- You are looking for short-term financing and plan to sell or refinance the home before you owe the lump sum payment.
- You are sure not to stay long in the accommodation and sell it before having to pay the fixed price.
Balloon loans may seem appealing given their low initial monthly payments, but they are not for everyone. Most borrowers today are opting for fixed rate mortgages because the rates are near historic lows, Woods says.
“Balloon loans are typically offered for higher risk lending scenarios, where the lender is unwilling to offer long term financing based on the current situation,” Woods said.