Do Balloon Loans Protect Mortgage Borrowers?

Column Distributed August 24, 1998 "You said recently that a borrower must refinance a balloon loan? Isn't the lender obligated to extend a balloon loan at the borrower's request? Isn't that valuable protection?" It is true that at the term of a balloon loan, usually 5 or 7 years, the lender is contractually obligated to refinance it, subject to certain conditions. The question is, how valuable is this obligation to the borrower? In my judgment, because of the conditions that hedge the commitment, it is worth little or nothing. If you take out a 5-year balloon today, the lender's obligation to refinance is at the rate the lender will be charging in 5 years. But under normal conditions, many lenders will be interested in refinancing a balloon loan and you will want to shop for the best deal available at the time. The lender offering the best deal on a balloon loan in 5 years is unlikely to be your current lender. Besides, changes in your financial circumstances or in the market during the 5 years may call for a different type of loan. Under these circumstances, the refinance commitment by the original lender is worth very little. A commitment by the original lender might be valuable under adverse circumstances, such as an economic reversal to the borrower or an explosion in market interest rates. But these are exactly the circumstances under which the lender takes himself off the hook. In all the balloon contracts I have looked at, the lender need not refinance the loan if the borrower has been late on a single payment in the preceding year, or if the lender's new rate is more than 5% above the old rate. The bottom line is that under normal circumstances you won't need a commitment from your existing lender because many lenders will want to deal with you, and under adverse circumstances the commitment doesn't hold. Copyright Jack Guttentag 2002

Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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