Arms & Balloons

There is often some consumer confusion regarding balloon and ARM or adjustable type mortgages.  Let’s start with the most common type of mortgage, and this is a 30 year fixed.  30 year fixed mortgages are what most consumers in the US use when borrowing money, this accounts for around 90% of all mortgages currently.  In case you are wondering the average 30 year mortgage rate in the US last week was 7.02%.   A lot of us, myself included, were really hoping for a noticeable drop in rates by now from what we’ve seen over the last couple years.

Back to the title of the article.  In our Northern Wisconsin area we do see a fair amount of balloon type and adjustable rate mortgages from a variety of different lenders and on a variety of different property types.  At Select One we often see these products when dealing with vacant land, older mobile homes, or properties that don’t fit the mold of conventional or other standards.  Many times those that are in a balloon or an ARM may be able to get into a fixed product and not be aware of it.

A balloon is a mortgage that is due in full at a predetermined time, typically well before the entire loan is paid off if one is making minimum payments required only.  A balloon mortgage is usually fixed in rate until the balloon payment is due.  When a balloon mortgage is due the borrower can pay it off in full, possibly renew it if the lender is offering that feature, or refinance the remaining debt.  Most of the time a balloon mortgage is written for 1-7 years and then amortized over 20 – 30 years.  What this means to the borrower is that if they make the minimum payments most of their payments will go towards interest, especially if they continually renew without shortening the amortization term.  Balloon mortgages place far more risk and uncertainty in terms of interest rates with the borrower then with the investor.

With mortgages the majority of the interest due will be during the early years of the product.  The danger with just simply renewing for another 5 year balloon with a new 30 year amortization is that you’ll be paying those earlier years all over again.  This type of situation can leave you with a perpetual mortgage that never gets paid off if you only make the minimum payments and renew balloon mortgages without decreasing the amortization period.  Paying extra towards principal or getting something amortized over a shorter period can help solve this.  

An ARM is an adjustable rate mortgage.  Typically these will offer a lower rate and potentially lower cost option in exchange for the interest rate being adjustable after a certain period of time.  Unlike a balloon most ARMs will not have a feature requiring payment in full before the term is fully amortized.  While the rate may fluctuate after the initial fixed period you can typically ride an ARM out for its full term, the rate will just adjust per the terms of the ARM.  Most ARMs are amortized over 30 years so you don’t have to renew or refinance them after the fixed rate period.  Sometimes it can make sense to refinance but a lot of ARMs today will still be attractive even if they adjust up after the fixed period is done.  This is due to the rapid increase in interest rates we’ve seen over the last year plus.  Just because an ARM is adjusting up doesn’t mean it still isn’t the best value today.  For instance if someone has a 5/1 ARM where the 5 year period is up and it is adjusting from 4.00% to 5.00% that is still going to be a better rate than anything available today.  

Balloons and ARMs have their place in the mortgage world but they are much more complicated and tougher to understand than a traditional fixed rate product.  Depending on your situation and goals they might be right for you.  At the same time it is imperative that if you pursue one of these options you completely understand it and fully evaluate your financial situation and future along with the potential impact of being in a product.  Both Balloon and ARM products are putting more risk on the borrower then a fixed product.  Life has a lot of variables, to me if you can get in a true fixed rate product for a similar or even slightly higher cost it makes sense in most situation, it eliminates at least one variable in life.