Balloon Mortgages Are Like ARMS... But They Can "Pop!"

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" Balloons are usually popular when interest rates are rising," Klumb says. What makes them attractive is they have a lower interest rate than a conventional, 30-year mortgage. " They are cheaper," he says, " so if you know you are going to be moving before the call date they're a good deal. After all, you know you're going to be selling your home." Problems arrive, however, if you don't move.

A balloon mortgage is similar to an ARM (adjustable rate mortgage), where the interest rate changes at a certain point, or points, over the life of the loan. Klumb says as a rule, five-year and seven-year balloon mortgages are cheaper than five-year and seven-year ARMS, normally by about one-quarter of 1 percent. " But we've been having some kind of inverted interest rate curve going on lately," he adds. " With interest rates in a state of flux, balloons and ARMs are currently at the same rate." Klumb says that if a person with a good, solid credit history could get either a five-year balloon or a five-year ARM for roughly 5 percent, plus one point, that same borrower could a get a 30-year conventional loan for roughly 6 percent, plus a point.

The lower interest rate is tempting. On a $100,000 loan the difference between 5 and 6 percent translates to $62.73 a month, or $752.76 a year. If you're planning to move at the end of five years, you would save $3,763.38 in interest payments. For a $150,000 loan the savings would be $94.10 a month, $1,129.20 a year, or $5,646 at the end of five years.

But what happens if you don't move at the end of the fifth year? You would either have to come up with $91,828.84 to pay off the $100,000 loan or $137,743.26 to pay off the $150,000 If you couldn't, you would have to refinance at whatever the going rate is or lose the house. While a balloon and ARM may start out at the same rate, that can change on the due date. " If you get a five-year ARM, you do not have to pay off the loan at the end of five years. It either converts to a fixed-rate loan, if that's the agreement you made when you took out the loan, or it would adjust at preset intervals thereafter," Klumb explains.

When you sign up for either a balloon mortgage or an ARM, no one knows what the interest rate will be on the due date. " But at least with an ARM you know what the upper limit will be. That's because most ARMs have built-in controls limiting how high the interest rate can jump in any one year, and how high the total interest rate can climb over the life of the loan." Some ARMS adjust once. Others may adjust several times, on the anniversary of the loan.

While balloon mortgages have historically lacked similar conversion options, Klumb says it is now possible to get them. These options are often complicated and they can be expensive. " There is one available through Fannie Mae. You end up paying whatever the rate is that Fannie Mae is selling its securities for at the time, plus an additional 5/8 (0.625), and that is rounded up. So, if the rate were 5.72 percent, for example, you would add another 0.625, which would bring it to 6.345 percent. Then, it would be rounded up to 6.5 percent. Freddie Mac has a similar program, but you have to make sure that your balloon has this sort of option when you take out the loan." You always have the option to covert to a standard 30-year-loan, however, if you don't like the conversion options.

It's a lot simpler with an ARM, which is why Klumb says if rates were the same, " I'd go with the ARM because of less volatility." Most ARMs have limits and a ceiling spelling out how high the interest rate can climb. In any one year, a rate could increase 1 percent or 2 percent. There is also a limit as to how high it can go over the life of the loan--often 6 percent. This doesn't mean that the loan will go that high, just that it can if interest rates rise sharply over a period of years.

Klumb says that if you have a balloon mortgage, you will normally be notified about 45 days before it comes due. This gives you time to shop for a new loan, if you need one. " Your lender will want to refinance the loan. Some have automatic options and will do so automatically. You need to know which kind you have: a true balloon or one with a rollover option. If it does have a rollover option, you need to know how that rate will be determined." And how it would compare with other options.

Even when there is a one-quarter-point difference between a balloon and an ARM, you have to decide if that quarter point is worth the risk you take with a balloon mortgage. On a $100,000 loan, a quarter point is roughly $15, which is less than $200 a year. On a $150,000 it's about $24 month, or less than $350 a year. Like party balloons, balloon mortgages can be attractive. Just remember they both can pop.