Is a Balloon Loan Better Than an ARM?

Balloon loans, also called bullet loans, are a special category of loans with a term of between three and seven years, but the payments are calculated on a term of fifteen years with the balance being due in one large payment at the end of the loan term. This means that your payments are much lower than for a regular mortgage, but you must be prepared to pay off the balance. You can do this with cash, or by refinancing or converting the loan to a regular mortgage at the current interest rates. Although lenders are usually required by the loan contract to refinance at the borrowers request, it is subject to many conditions and refinancing or converting the loan will require additional paperwork and settlement costs.

Many people will use a balloon loan when they are refinancing, or when they anticipate a major influx of cash in the future, such as from a settlement or inheritance. Comparing a Balloon Mortgage to an ARM: It is useful to compare five and seven-year balloons with ARMs that have the same initial rate periods. Both offer a rate in the early years below that available on a fixed-rate mortgage, and both carry a risk of higher rates later on. But there are some important differences. Favoring the Balloon: Balloon loans are much simpler to understand and therefore easier to shop for. The interest rate on a five-year or seven-year balloon is typically lower than that on a 5/1 or 7/1 ARM.

Favoring the ARM: The risk of a substantial rate increase after five or seven years is greater on the balloon. The balloon must be refinanced at the prevailing market rate, whereas a rate increase on most five- and seven-year ARMs is limited by rate caps.

Borrowers with five- or seven-year balloons incur refinancing costs at term, whereas borrowers with 5/1 or 7/1 ARMs don't unless they elect to refinance. Borrowers who are having payment problems may find it difficult to refinance balloons. The balloon contract allows lenders to decline to refinance if the borrower has missed a single payment in the prior year. This is not a problem with ARMs, which need not be refinance. Borrowers may find it difficult to refinance balloons if interest rates have spiked. The balloon contract allows lenders to decline to refinance if current market rates are more than 5% higher than the rate on the balloon.