Are Prepayments on a Balloon Loan Wise?

May 24, 1999, Revised August 28, 2011

"I recently purchased a condominium financed by the seller at 5.5% interest over 34 years, with a balloon due in 10 years. Is it wise for me to make extra principal payments so that the balloon payment will be smaller, or should I invest my extra income in other ways?"

With a balloon loan, the borrower must refinance the loan balance at the end of a specified period, or be in default. While in some balloon loan contracts the lender has an obligation to refinance, the obligation is hedged in so many ways that borrowers would be foolish to depend on it. See Do Balloon Loans Protect Borrowers? On a balloon loan provided by a home seller, you can safely assume there is no obligation at all to refinance. You will have to access the market.

Positioning Yourself to Refinance

Your objective is to position yourself to refinance the loan balance in 10 years at the most advantageous terms possible. That means having good credit, and accumulating enough equity in the property that you are classified as a low-risk borrower. Your loan balance after 10 years should be no more than 95% of property value at a maximum. 80% would be even better because it would allow you to avoid paying for mortgage insurance.

You may be helped in meeting that objective by rising home prices, or you may be hindered by falling prices, but you have little control over that. What you do control is your loan balance. I would develop a payment plan that would result in having a loan balance no more than 80% of current house value. You can find the monthly payment that would give this result using my calculator 2a Extra Monthly Payments.

Paying Down the Balance Versus Accumulating an Investment Fund

Would you do better putting the extra payments in an investment fund, which could then be used to pay down the balance just before entering the refinance market? No, making the same payment into an investment account would generate a smaller balance reduction because you could not earn 5.5% on such an account. When your extra payment reduces the balance on a 5.5% loan, you earn a return on your investment of 5.5% with zero risk. You can't beat that anywhere else. See What Is the Yield on Mortgage Prepayment?

BUT to get the full benefit of extra mortgage payments, the party servicing your loan must keep proper accounts. If you add $100 to your monthly payment, the interest due the following month should be calculated on a balance from which that $100 has been deducted. This happens automatically on a loan from an institutional lender, but a home seller might be using a back-of-the-envelope accounting system that does not properly credit your prepayment. You need to make sure that doesn't happen.

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