5 Reasons to Avoid a Loan With a Balloon Payment

1. You'll Need to Repay or Finance a Large Payment

The final payment on a balloon payment loan can be twice your regular monthly payments or more. A balloon mortgage loan, for example, could have a final payment of tens of thousands of dollars. If you don't have the money on hand to make the balloon payment, you'll have to find it—possibly by refinancing your loan or taking out another loan. House flippers sometimes use balloon mortgages because they plan to sell the home before the balloon payment comes due. But if the housing market slumps, it could be difficult to sell the home. Even if you find a buyer, you may not get enough from the sale to cover the balloon payment.

2. You May Pay Higher Interest

Some balloon mortgage borrowers plan to refinance their loan before the balloon payment comes due. Suppose you're in law school, with the promise of a much higher income upon graduation. You could use a balloon mortgage to buy a home with lower payments that fit your current income, and refinance into a traditional mortgage when you get a job. Should interest rates rise by that time, however, your new loan could be costlier than you anticipated.

3. You May Need to Pay New Closing Costs

Refinancing a mortgage typically involves closing costs that may range from 2% to 5% of the home's price. Closing costs can add up to several thousand dollars, eating into any savings you enjoyed from the lower monthly payments of the balloon payment loan.

4. It Takes Longer to Build Equity

Some balloon mortgages are interest-only, meaning you don't pay anything toward the loan principal until the balloon payment. Others include payments of both interest and principal. Either way, because these are short-term loans, you'll generally build little or no equity in your home by the time the balloon payment is due. Home equity is a valuable tool you can use to access credit such as home equity loans, home equity lines of credit (HELOCs) or a cash-out mortgage refinance.

5. You Could Lose Your Home

Your home serves as collateral for a balloon payment mortgage loan. If you can't make the balloon payment, the lender can foreclose on your home. This could seriously impact your credit, making it more difficult to get a mortgage or even rent a home in the future. Avoiding foreclosure might require selling the home to cover the balloon payment.

Alternatives to Balloon Loans

Improving your credit score, making a bigger down payment or choosing a less expensive home can all help you lower your monthly mortgage payments without getting a balloon loan. Other types of mortgages that may reduce your monthly payments include:

Conventional Mortgage Loan

Any mortgage not guaranteed by a federal government agency is called a conventional mortgage. Available from financial institutions such as banks and credit unions, conventional mortgages can be had with a credit score as low as 620. You may be able to get a conventional mortgage with a down payment of as little as 3%; there are even conventional mortgages with 100% financing.

FHA Loans

Loans guaranteed by the U.S. Federal Housing Administration (FHA) are tailored for borrowers who might not otherwise qualify for mortgages. Available from banks, credit unions and other financial institutions, FHA loans have more lenient lending standards than conventional mortgage loans. Depending on the size of your down payment, which can range from 3.5% to 10%, you may be able to get an FHA loan with a credit score as low as 500.

VA Loans

Military service members, former service members and their surviving spouses may qualify for a mortgage loan through the Department of Veterans Affairs (VA). In a VA loan, the federal government guarantees up to 25% of the value of your home if you default on the loan. Thanks to this guarantee, you may be able to get a VA loan with a credit score as low as 620. VA loans generally offer lower interest rates than conventional mortgages, don't require paying private mortgage insurance (PMI) and may not require a down payment.

USDA Loans

Low- or moderate-income households purchasing a house in eligible rural or suburban areas may qualify for the U.S. Department of Agriculture's Rural Development Guaranteed Housing Loan Program. Designed to help people who might not otherwise be able to afford homes, USDA loans require no down payment.

Adjustable-Rate Mortgage

Adjustable-rate mortgages (ARMs) usually have lower interest rates than fixed-rate mortgages, which can mean lower monthly payments. After an introductory period ranging from one to 10 years, the interest rate is regularly adjusted based on current interest rates. Conventional loans, FHA loans and VA loans are all available as ARMs. Although ARM interest rate adjustments are typically capped, there's still the risk that if interest rates rise, your payments could increase.

Rent Instead of Buy

There are pros and cons to both buying and renting a home. Although home ownership is typically cheaper than renting in the long run, in many parts of the country, renting is substantially cheaper on a monthly basis. In Austin, Texas, for example, renting could save you an average of $1,822 per month compared to buying, Realtor.com data shows. Depending on your location, it may make more financial sense to keep renting and use the savings to build up a bigger down payment. Having a down payment of 20% can make it easier to qualify for a mortgage with low interest rates and fees.

Put Your House in Order

A balloon payment loan is one way to reduce your mortgage or auto loan payments, but could expose you to unnecessary risk. Getting your credit in good shape can help expand the mortgage options available to you without the need for a balloon loan.

Before applying for a mortgage, check your credit score and get a copy of your credit report from each of the three major credit bureaus (Experian, TransUnion and Equifax) by visiting AnnualCreditReport.com. If necessary, take steps to improve your credit such as paying bills on time, reducing your credit card balances and not applying for new credit. Need inspiration? Use FICO's Loan Savings Calculator to see how even a small boost in your credit score could save you thousands of dollars over the life of your mortgage.