Comparing a Balloon Mortgage to an ARM

A balloon mortgage and an Adjustable Rate Mortgage loan, or ARM, each offer advantages to a home buyer. Which loan is right for you will depend on your financial circumstances when you take out the loan, where you believe interest rates are headed and what kind of financial shape you believe you'll be in a few years.

Balloon Loan Basics

A conventional mortgage has a fixed interest rate for 30 years. But many people cannot qualify for that because their current financial situation does not fit within guidelines.  With a balloon loan, a lender offers you a short-term loan on a lesser amount with a final, large - or "balloon" - payment. As an example, a $100,000 home might be financed with a 10-year, $50,000 note with a $50,000 lump-sum due at the end.

Benefits and Drawbacks

The primary benefit of a balloon mortgage is it's ability to offer financing and allowing you to complete a home purchase now that you might not otherwise qualify for.  You are borrowing a smaller amount, typically at a competitive interest rate.

The drawbacks of a balloon mortgage center on the increased risk. You are betting that you will be able to qualify for a loan to meet the balloon payment, that you will have cash to pay it or that you can sell your home and pay it. In each case, the unknown risk factors make a balloon mortgage less attractive.

Two elements that mitigate those risks are time and predictability. You know when the balloon payment is due and can begin preparing for it far in advance.

ARM Basics

An Adjustable Rate Mortgage is a long-term loan with two steps. In step one, the lender offers you a lower interest rate for a given period. Two to three years is the typical term of an ARM, but one to 10 years is not unusual. The lower rate allows you to qualify for the loan at the lower monthly payment. At the end of that adjustable rate period, the interest rate adjusts to a, typically, higher rate. Some ARMs adjust to a predetermined interest rate, others adjust to the current market rate.

At the adjustment time, you can pay the new rate or refinance the loan, paying off the remaining balance. You refinance only if rates are lower or the terms of the new loan are more advantageous. In either case, the goal is to maintain or lower your monthly payments.

As with the balloon mortgage, time is on your side. You can't control where interest rates will go, but you do know when you must take action and can prepare for it.

Benefits and Drawbacks

Again, as with a balloon mortgage, the primary benefit is to purchase a home now that you could not otherwise, because you are qualifying for a loan with a lower monthly payment temporarily. If you believe the housing market is strong and plan to sell your home within the low-rate period, you can buy and sell a home for a profit with less money out of pocket.

The drawback of an arm is you are banking on a strong housing market, lower interest rates or that your financial position will improve enough to cover the higher payments.

For most borrowers, an ARM poses less risk than a balloon mortgage because you don't have to pay off the loan or refinance. You have the option of simply staying and paying the new rate.