Balloon Loans and Two Step Mortgages
 alloon loans are short term mortgages that have some features of a fixed rate mortgage. The loans provide a level payment feature during the term of the loan, but as opposed to the 30 year fixed rate mortgage, balloon loans do not fully amortize over the original term. At the end of the loan term there is still a remaining principal loan balance and the lender generally requires that the loan be paid in full. Balloon loans can have many types of maturities, but most balloons that are first mortgages have a term of 5 to 7 years. Many times sellers of real estate carry back a portion of the equity between the sales price and new loan amount as a second mortgage with a 3 to 5 three maturity. Many times these second mortgages are interest only loans and no principal payments are made during the term of the loan.
The secondary market purchases balloon loans from mortgage lenders and has helped create balloon loans that have refinance options at the end of the balloon period. Sometimes balloon loans have features that allow borrowers to convert the mortgage at the end of the balloon period to a fully amortizing loan based upon the outstanding principal balance and the current interest rates. For example, at the end of a 5 year balloon loan term, a mortgage will convert to a 25 year fully amortizing loan based on the current interest rates; at the end of 25 years the loan will be paid in full. Other times, balloon loans may convert to an adjustable rate mortgage (ARM) at the end of the balloon period.
As with fixed rate mortgages, many balloon loans are sold into the secondary market. They are aggregated with other balloon loans with similar characteristics, such as note rate, term etc., and converted into mortgage backed securities and bonds. These securities are purchased by investors that acquire capital market investments, such as corporate bonds, U.S. government securities, etc. Generally, the yields on balloon loans track the maturities of other capital market debt instruments. Because balloon loans are considered short term mortgages, the interest rates are generally lower than 30 year fixed mortgages.
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