Jed needed money to make some home improvements. His plan was to update the kitchen and to add a garage. Jed didn't have enough money in savings to pay for the improvements outright, so he decided to apply for a home equity loan. Jed's mortgage loan offered him a loan with very low monthly payments. However, the mortgage lender said that, at the end of five years, there was a balloon payment due. Jed is unsure what the mortgage lender means.
Generally, when a borrower obtains a mortgage loan, the borrower repays a portion of the principal, as well as interest, with each monthly payment. In addition, the borrower pays taxes and insurance as part of the monthly payment. During the early stages of repayment of a traditional mortgage loan, the borrower repays very little principal and quite a bit of interest. A mortgage loan with a balloon payment provision is very different from a traditional mortgage loan. Usually, mortgage loans with balloon payment provisions are second mortgages as opposed to first mortgages (also known as purchase-money mortgages). With such a loan, the borrower may be required to pay interest only or may be required to pay some combination of principal and interest, plus the customary costs of taxes and insurance. The significant difference between a traditional mortgage loan and a mortgage loan with a balloon payment provision is that the latter loan requires that the loan be repaid in full at the end of some specified period.
The main reason borrowers opt for mortgages with balloon payment provisions is that such loans usually require smaller monthly payments during the initial repayment period. The risk of obtaining such a loan is that the borrower will not be able to repay the balloon payment at the end of the loan term and may, as a result, lose the home.
A borrower considering a mortgage loan with a balloon payment provision may wish to ask the following questions:
- How long do you plan to stay in the home?
- What is the current interest rate?
- Are there any indications that the interest rate will increase sharply in the future?
- What is the maximum monthly payment you can afford?
- What is your plan for repaying the balloon payment?
- Can you convert the mortgage into some other type of mortgage?
- What is the cost of the loan to you, including closing costs?
- Are there other financing options available?
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