Balloon loans are mortgages that operate on a lump-sum payment schedule, meaning at some point in your loan’s life—typically at the end—you’re required to pay the remainder of the balance at once.
You might only pay interest for the life of the loan, followed by one large principal payment at the end, or a combo of interest and principal with a smaller lump-sum payment due at the end, depending on your lender.
Balloon loan monthly payments are low. You can also use the leftover money for other things, including building credit or savings, before your lump-sum payment is due. But keep an eye out for the balloon part!
Interest-only mortgages are comparable to certain balloon loans because they allow borrowers to only pay their loan’s interest for their monthly payment instead of the interest and principal.
But, unlike a balloon loan, an interest-only mortgage only allows the borrower to take advantage of these interest-only payments for a certain number of years. After that, the balance starts to amortize, significantly raising the monthly payment.
The majority of interest-only loans are ARMs, which means the interest rate is adjusted several times per year, based on current rates. This causes the monthly payments to fluctuate, which can make it harder to budget.
There are also interest-only fixed-rate mortgages, but this type of mortgage is extremely rare.
Amortized vs. Interest-only Payment Schedules
Interest-only mortgages can be used in the following situations:
- As a construction loan to cover the cost of the land and home construction. Once construction is complete, the loan converts to a fully amortized loan.
- Borrowers with high net worths who don’t want to tie up a large chunk of capital in a residence, and who have no problem periodically refinancing into new interest-only loans.
- Borrowers looking at the property as an investment and planning to sell it within a couple of years who want to minimize their expenses.
Interest-only mortgages generally require a substantial down payment and an excellent credit score. They are higher risk for lenders as the payments can go up dramatically once the borrower starts paying principal, so this checks out.
Search “amortization calculator” online to visualize what your monthly payments would be for fully amortized versus interest-only ARM loans.
In summary, you have a range of loan options with varying amortization schedules. Make sure that you know what you’re getting into when you choose one—look beyond the monthly payment, to the principal and interest splits, the rates (fixed or adjustable), and whether or not prepayment penalties apply.