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Balloon Mortgages: A Relic of the Boom Survives?

Honestly, I thought balloon mortgages--loans that come due after a short period, forcing a refinance--were killed off by the real estate crash. But I learned that online lender ING Direct is still offering these risky loans. Only now they're taking steps to limit their own risk by requiring at least a 25 percent down payment (or equity, if it's a refinance).

The payoff for borrowers: A 4.25 percent interest rate, which is well below current rates. And ING Direct promises very low closing costs, too.

Company officials said they're aiming these loans at customers who have demonstrated an ability to save money, hence the 25 percent down payment requirement. And they say various features of the loan will allow borrowers to pay off their homes more quickly than if they took out a traditional mortgage.

But borrowers assume big risks in return for that low rate.

This loan requires bi-monthly payments. You send in half of the monthly payment every two weeks.(They penalize you if you send it any way but by electronic debit.) That adds up to one extra mortgage payment each year. It does help you pay off the mortgage faster--and therefore helps you build equity more quickly. But, with more cash going out of your checking account each year, your budget will feel the pinch. Plus, under this loan, you don't have the option of dropping back to a regular 12-payments-a-year plan.

Of greater concern, however, is that balloon feature. Your interest rate is fixed at 4.25 percent for five years. After that, the entire unpaid balance comes due. Loan payments are calculated as if you would be paying off the loan over 30 years.

Oh, and there's a yet another catch: If you pay off the loan during the first year, for whatever reason, including the sale of your house, you owe a prepayment penalty equal to 3 percent of the outstanding balance.

Scott Lugar, head of home sales and mortgage home loans for ING Direct, said that the bank will refinance anyone who has a good payment history and that a full evaluation of the borrower's credit status won't be required. (That's good news if you happen to fall ill or get laid-off right at that five-year mark.) But you then would be captive to ING Direct for that refinance. Under such conditions, no other lender would approve a loan for you.

Also, at that five-year refinance point, there are no caps limiting how high your interest rate could go. You would have to refinance at the current market rate. Considering that mortgage rates are now near historic lows, that would certainly give me pause.

And, your price to refinance that loan? One month's worth of mortgage payments. That would not reduce your debt; it would simply be considered a fee to the bank.

I was surprised to come across a loan like this, given all that has been learned from the financial crisis. Does it sound appealing to you?

By Elizabeth Razzi  |  July 13, 2009; 6:00 AM ET
Categories:  Mortgages  
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The problem isn't the product -- it's how it's used. Fundamentally, a balloon nowadays isn't that different from an ARM, because most balloons have written into them an automatic refinance option. The problem isn't the balloon itself; the problem is when people have to use a balloon or ARM because they can't afford the house using a regular fixed-rate mortgage (or when lenders/brokers don't clearly explain all of the risks and make sure people have done the math).

This is still a country where most people don't stay in their homes (or loans) for more than @ 5-7 yrs. So why wouldn't it make sense to get a lower rate for those first 5-7 yrs, especially if you know going in that this is not your permanent house?

That's exactly what I did on my first condo, way back in the early nineties. Interest rates were 8-9% then; a 7/23 balloon got me a full 1% rate reduction over a 30-yr fixed, with an automatic refinance to a rate that was @ 3% higher if I passed the 7-yr mark. I did the math, and the overall interest rates would have been a better deal than a 30-yr fixed up to about 10 years. Was a reasonable risk to take at the time. Would I do it now? No, because we are in what I hope will be our permanent home now, so it doesn't suit our circumstances. And I wouldn't use this particular mortgage because I refuse to get ANY mortgage with a prepayment penalty, period.

It really, really bugs me when people act as though all of our problems can be laid on the back of some particular product, because it's a dangerous distraction that keeps us from focusing on the real problem. We find a scapegoat, we can tell ourselves that just stopping X will prevent the problem in the future. We stop X. We feel "safe," like we are back in control of the situation. But in reality, the same risks are still out there -- and we're ignoring them, because we're so focused on how to save ourselves from X.

Loan are just tools. When used properly, they can be incredibly helpful. When used improperly, they can do tremendous damage. Kind of like a knife. We all know knives are dangerous and can kill you. But a knife can also save your life scuba diving if you get tangled in monofilament line.

Posted by: laura33 | July 13, 2009 8:36 AM | Report abuse

I will point out that, unlike a good ARM, this loan's refinance feature allows for no interest-rate caps whatsoever. Some knives are better than others.

Posted by: Erazzi | July 13, 2009 9:29 AM | Report abuse

I also had a 7/23 in the mid-90s under similar circumstances. I agree with Laura's assessment--while this particular balloon loan doesn't seem to be a good deal, and a balloon loan does not suit my needs at this time, the balloon loan I had back then was good for my then circumstances. As with all loan products, the devil is in the details of the loan and of the borrower's circumstances. It's a gamble. A friend of mine is a loan officer and his advice to me at the time was--the only safe loan is a fixed rate loan, but that may not be the best loan for you. He advised me from afar (no financial conflict of interest) and I took the balloon loan based in part on his recommendation.

Posted by: janedoe5 | July 13, 2009 2:43 PM | Report abuse

More bad news for the housing industry

Posted by: cavatellie | July 13, 2009 6:58 PM | Report abuse

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