How Does a Balloon Payment Work?
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Terms
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When you borrow money for a mortgage loan which is not fully amortized over the life of the loan, there will be a balloon payment due, which is a large lump sum payment. These balloon payments are due at maturity or at some period of time specified in the contract, such as five years or 10 years. Up until the balloon payment is due, all payments received are amortized, which means a portion goes to principal and a portion to interest. Balloon payment loans can have a fixed interest rate or a variable rate. The amount of the balloon payment is normally included in the language of the contract, if the truth-in-lending provisions are applicable to the mortgage loan.
Reset
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When it's time for the balloon payment to be paid a borrower will have several options at his or her disposable. The mortgage balance can be reset based on the established market interest rates. The balance will be fully amortized based on a new schedule of payments for the new term, whether it's for 15 or 30 years. The loan can be reset automatically or the borrower may be required to meet certain requirements, such as no payments 30 days late within the past 12 months, no liens against the property, no large reduction in the borrower's income, and the borrower may have to live in the home. When you have a balloon payment due, the reset option presents less risk than all other options available. All of the terms will be stated in the contract.
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Options
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Sometimes a borrower will not have the option to reset the balloon payment. If there is no reset option, then the borrower will have to try to refinance the balance, sell the property, or have enough money set aside to pay off the entire balance. There are certain risks that the borrower is subjected to when it comes to refinancing the loan. If the borrower does not meet the lender's requirements he may not be able to have the loan refinanced. When the value of a home falls substantially it makes refinancing very difficult due to a lack of equity. Selling the home could be difficult if the economy is slow and homes are not selling like they would during more vibrant times. It can be very difficult for most people to get their hands on a large lump sum on money to pay off the entire balance when due.
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