A balloon mortgage is one on which the outstanding balance is due at some point before amortization has paid off the balance in full. Aside from the repayment obligation, balloon loans are identical to standard fixed-rate mortgages (FRMs).

For example, if a five-year balloon loan for $100,000 is at 5 percent for 30 years, the initial payment of $537 would be the same as on an FRM, with the same rate and term. The difference is that on the balloon loan the balance of $91,829 after five years must be repaid. At that point, the loan may be extended at the current market rate, or refinanced with the current or a different lender.

In Canada, one- to five-year balloon mortgages have long been the standard instrument. They have been less common in the U.S., but a number of them were written in the years immediately prior to the financial crisis, with balances due in five or seven years. That means that they are now coming due.

I’ll discuss some frequently asked questions about balloon loans below.

Refinancing out of a balloon: Borrowers with balloon mortgages who are able to refinance, either with their existing lender or another lender, may be concerned about the timing.

Q: I have a balloon payment due Jan. 10, 2012, and am refinancing with a different lender who is taking his time, and I am getting nervous. What will happen if the new loan is not closed until after the due date on the balloon?

A: Nothing very serious will happen. The lender holding the balloon will charge interest for each day of delay beyond the due date, but that’s all. However, it is a good idea to keep both lenders informed about your progress.

Refinancing a balloon when you are underwater: The borrower with a balloon balance larger than the property value has a more serious problem:

Q: We have a balloon payment due in December 2012. The current balance on the mortgage is around $150,000. The house might sell in today’s market for $125,000. Is the lender required to refinance it?

A: I have never seen a balloon mortgage note that requires the lender to refinance, but when a mortgage is underwater, that doesn’t matter. Because no other lender will refinance an underwater mortgage, either your current lender refinances it or you will be forced to default.

Expect an offer to extend the term for another five years at the same rate. If you have problems making the payments on this mortgage, you don’t have to accept the offer.

Paradoxically enough, your lack of options gives you negotiating power. Your existing lender knows you have no other options except to default, which would impose a large loss on the lender. A much better outcome from his standpoint would be a refinance that would keep your payments coming. That way, you might eventually pay off the loan. If necessary, the lender should be willing to relieve your payment problems by modifying the loan terms.

The bottom line is that the deal that emerges is the one you negotiate. My negotiating position would be to refinance a balance about equal to the value of the property. An alternative might be a significant drop in the interest rate. If they understand that you view your choices as either refinancing at terms you can afford or defaulting on the mortgage, they should be reasonable.

But note the potential hazard illustrated by the letter below:

Q: I have a credit issue with trying to refinance the first mortgage on my property. I had a second mortgage but paid off the $400,000 balance in response to an offer from the second mortgage lender to accept $250,000 as payment in full. I was delighted to do this because I believed it would leave me in a good position to refinance the first mortgage.

My credit was always excellent. Then I discovered that the second mortgage lender had reported the transaction to the credit agencies as "paid for less than full balance," which caused my credit score to drop like a rock and prevents me from refinancing the first mortgage.

A: Credit score write-downs have plagued the mortgage modification programs, including those under the federal Making Home Affordable program. Borrowers with underwater balloon mortgages coming due who seek a private modification deal face the same problem. The issue of how the transaction will be reported to the credit bureaus should be one of the factors negotiated with the lender.

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