There are situations where a conventional 30-year mortgage isn't your best choice. For example, you might have a job that requires you to relocate every few years. In that case, you might want to consider a 5/25 mortgage.
TL;DR (Too Long; Didn't Read)
A 5/25 mortgage might require a balloon payment after five years.
5/25 Mortgage Basics
The mortgage industry has designed many different products to accommodate the financial requirements of homebuyers. One such product is the 5/25 mortgage, which has the following characteristics:
- The mortgage has a five-year initial phase in which the borrower pays fixed monthly payments.
- The lender figures the monthly payments as if the mortgage had a regular 30-year term.
- After five years, the homeowner must make a balloon payment for the full remaining balance on the mortgage.
- However, the loan agreement gives the homeowner the right to reset the mortgage for the remaining 25 years, usually at a different rate, and avoid the balloon payment.
How Mortgage Amortization Works
To evaluate the 5/25 mortgage, you’ll find it helpful to understand how mortgage amortization works. Typically, homebuyers agree to a 30-year mortgage that calls for a fixed payment every month for 360 months. The mortgage is amortized, meaning that payments in the early years are mostly interest, with little going toward the pay back of principal. Over time, the split between principal and interest changes and by the end, nearly all of the monthly payments repay principal.
Amortization Period Vs. Loan Term
In a 5/25 mortgage, the lender applies a 30-year amortization schedule, as if the homebuyer was taking out a conventional loan. However, the loan calls for either a balloon payment at the end of five years or the resetting of the loan. Thus, a 5/25 mortgage has a five-year term but a 30-year amortization schedule.
If all goes well, the homebuyer will have the opportunity to reset the loan rather than make the balloon payment, take out a new loan or sell the house. The reset loan will have an amortization period of 25 years. The interest rate on the reset loan may be fixed or variable and need not equal the original rate.
Balloon Payment Example
You can create an amortization schedule with balloon payment in Excel to see how much you would owe after five years. You can do this easily by downloading an Excel loan amortization template from Microsoft. The balloon payment due in five years equals the principal balance remaining at that time. For example, imagine a 5/25 mortgage with the following characteristics:
- Mortgage amount: $200,000
- Annual interest rate: 5 percent
- Amortization period: 30 years (360 months)
- Balloon payment: Due in five years
The spreadsheet shows that the monthly payment on this mortgage, ignoring other costs such as mortgage insurance, is $1,073.64. At the end of five years, the balloon payment amount will equal $183,657.46.
Resetting a 5/25 Mortgage
The borrower can reset the mortgage rather than make the balloon payment. However, the lender will typically have several requirements, which might include:
- The borrower must be up to date on payments and have never missed a payment by more than 30 days.
- The borrower hasn’t taken out secondary financing.
- The borrower agrees to pay certain fees for processing the reset and performing a new title search.
- The new interest rate is within a set range relative to the original rate.
The new rate will be described in the loan agreement. Normally, it is based on a current rate index plus an extra amount called a spread.
Balloon Mortgage Pros and Cons
The reasons to pursue a balloon mortgage include:
- Interest rates might be lower in five years.
- Current balloon mortgage rates are lower than those for a 30-year conventional mortgage.
- You might not plan to stay in the house for more than five years.
- It might be easier to qualify for a balloon mortgage than it is to qualify for a conventional 30-year mortgage.
Possible negatives include:
- You could lose the option to reset the mortgage if you are sufficiently late on a monthly payment.
- You will have to pay extra fees to reset the loan.
- Interest rates might be higher in five years.
- If you can’t reset the loan or make the balloon payment, you will have to find a new refinancing loan or sell the house.
- You won’t be able to take out a home equity loan or second mortgage before reset.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.