What Do You Know About Balloon Loans?

They’re certainly rare!  But they’re still out there.  Collateralizing properties in both first- and second-lien positions.  And even though you may never personally encounter or originate one, for NMLS testing and mortgage training purposes, in general, you’ll need to know about balloon loans.

A balloon mortgage loan’s payments are calculated based on a 30-year amortization.  But, when the market fosters a high lender/investor appetite for balloon loans, their interest rates will be priced lower than the 30-year, fixed-rate loan.  So it’s a 30-year-amortized payment at an interest rate that’s lower than the standard 30-year, fixed-rate loan, right?  Sounds like a no-brainer to me!  But wait!  There’s always a catch!

Although balloon loans offer lower interest rates than their 30-year, fixed-rate counterparts, the reason why they’re called “balloon loans” is because, at a specific “call point,” the borrower must be prepared to pay off the loan’s entire remaining balance.  And if the borrower is unable to satisfy the balloon loan’s entire remaining balance through either refinancing, liquidating cash on hand, or selling the property, the next stop on that train is Foreclosureville.

So why might someone take a chance on such a potentially-troublesome loan option?  Well, let me begin by saying that it’s the mortgage loan originator’s responsibility to ensure that the borrower is thoroughly aware of exactly into what he or she is getting him or herself by pursuing a balloon loan.  If the borrower thoroughly understands all associated risks, qualifies for the loan, understands all of the loan’s benefits and drawbacks, and still elects to pursue it, the MLO has properly performed his or her job.

Similar to the motivations behind pursuing adjustable-rate mortgages, reasons why a homeowner might select a balloon loan consist of:

• The borrower is attracted to the lower interest rate while intending to liquidate the property within only a few years;
• The borrower possesses the money to fully satisfy the loan but wants to take advantage of a lower interest rate than would otherwise be available;
• The borrower anticipates an increase in income while maintaining the qualifying credentials to eventually refinance; and
• The borrower is unable to qualify for a higher rate but possesses the money to pay the loan off in full when required.

Balloon loans are also referred to as “call loans,” “demand loans,” and “bullet loans.”  All four terms refer to the same thing.  And, similar to adjustable-rate mortgages, all balloon loans are described by two numbers separated by a forward slash.  There are two types of balloon loans:

1. Those that contain a conditional right to modify (CRTM); and
2. Those that do not contain a conditional right to modify (CRTM).

If the balloon loan contains a CRTM, the first number of its description will be the year of its call.  The second number will represent the difference between that call year and the loan’s 30-year amortization.  For example, if the balloon loan was described as a “3/27,” then this would represent a balloon loan with a three-year call and a CRTM.  The lower the call term, the lower the loan’s interest rate. Therefore, a 3/27 would be priced lower than a 5/25 which would be priced lower than a 7/23, lower than a 10/20, and lower than a 15/15.  And, as previously mentioned, in a market facilitating a high lender/investor appetite for balloon loans, all balloon loan options will be priced lower than the 30-year, fixed-rate mortgage.

Balloon mortgage loans that contain a CRTM are less risky than balloon loans that do not.  This is because, if the borrower meets the five conditions associated with the CRTM, instead of having to satisfy the loan at its originally-established call point, the mortgage servicer will simply extend the remaining balance for the remainder of the 30-year term at the new fixed interest rate.  The five conditions constituting the CRTM are as follows:

1. The borrower’s loan must be current (not delinquent by 30 days or more);
2. The borrower must reside in the property:
3. The borrower must demonstrate the absence of any subordinate liens (and, as such, may be required to purchase a title search);
4. The new interest rate offered by the servicer to modify the loan may be no more than 5% higher than the borrower’s current interest rate; and
5. The borrower would be required to initiate the modification with his or her servicer no later than 45 calendar days prior to the loan’s call date.

If all five conditions are met, the borrower simply signs some documents, pays a fee, and the loan continues at the new interest rate.  If, however, the borrower is unable to satisfy one or more of those conditions, he or she would be required to refinance the loan, personally satisfy its outstanding balance, or sell the property.  If he or she was unable to accomplish any of those options, the servicer would be left with no choice other than to commence foreclosure proceedings.

If the terms of a borrower’s balloon loan do not contain a conditional right to modify, he or she would simply have to satisfy the outstanding loan balance prior to or on the call date to avoid foreclosure.  A description of a balloon loan that does not contain a CRTM begins with the amortization term (in months or years) followed by the call term (in months or years).  If the first number is described in years, so will be the second number.  If the first number is described in months, so will be the second number.  Examples would be a 30/7 or a 360/84.

Although, and as mentioned, balloon loans are rare, a mortgage loan originator should possess a solid working knowledge of them.  Not only for NMLS testing purposes, but, if a balloon loan ever presented as a customer’s best solution, the MLO would have to know about them in order to appropriately counsel his or her customer.  Even if a balloon loan never presented as a borrower’s best possible option, imagine the amount of damage that the MLO’s credibility would sustain if, when asked by a potential customer to explain balloon loans, the MLO’s only available response was, “I’m not familiar with those types of mortgages.”