On a traditional mortgage loan, borrowers pay
only interest for several years. Then, as they
still pay off interest, more of their monthly
payment goes toward chipping away at the principal.
At the end of the term, they owe nothing.
But loans that are not fully amortized -- where
the principal is NOT paid off over the life of
the loan -- are set up for a "balloon"
payment. This is when the borrower has been paying
only the interest, or some combination of interest
and principal, and when the loan term expires
the balance is due in full.
The balloon payment is more common to second
mortgages. If you borrow $20,000, for example,
and your monthly payments for 10 years have included
only interest, you must fork over the $20,000
in principal at the end of the term.
Borrowers sometimes do this to make their monthly
payments more manageable. But after coasting along
with easy payments, a balloon payment can be an
ugly ending. You don't know how interest rate
cycles are going to change several years down
the road, and you can't look into the future and
know the exact worth of your home. And if you
can't pay your balloon off at once, you could
lose your home.
Some borrowers refinance the loan, obtain another
loan or sell their house to pay the balloon.
The bottom line: Steer clear of balloon payments.
If you can't, make sure, make very sure, you can
sell your house or come up with the dough some
other way.
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