Question

Derrick is going to graduate from college in three months with a degree in criminal justice. However, his real passion is real estate and he has found his dream home. Derrick has the option of getting a conventional loan or a balloon mortgage. He “knows” he will be making more money when the balloon payments increase in three years. The monthly payment of the conventional loan is $1,000. The monthly payment for the balloon mortgage is $700 for the first three years, and then it jumps to $1,300 after that. At his current job, Derrick makes enough to cover a $1,000 mortgage payment.

Is the conventional loan the better option for Derrick? Why or why not?

Should Derrick take advantage of the balloon mortgage? Explain your answer.

Are there any better options available to Derrick that he hasn’t thought about yet? If so, what are they?

What would you advise Derrick to do in this situation? Justify your answer.

Answer 1

A balloon mortgage is short-term loan which involves paying lower amount of interest and installments in the short run. The mortgage holder makes a large payment to cover the remainder of the principal during later periods.

Although this kind of mortgage is good for investors who do not have enough cash flows in the short run, they also come with significant disadvantages.

Some of the reasons that Derek should go for a conventional loan are -

1. Balloon mortagages have significant risk. They do not pay down much of the principal amount, mortgage holders have a significant financial obligation at the end of the loan's life. Derek will have to pay a significant portion of the principal at the end of his loan's life.

2. In case of certain unforseen circumstances, if Derek can not repay the lumpsum at the future date, he would need to refinance the loan. In case the interest rates have increased, he would find himself in a trap.

3. If the interest rates have risen or if his credit rating has deteriorated, it would be significantly difficult to refinance the mortgage.

Therefore, a conventional loan is a better choice to make, especially if he can afford to make $1000 payments today.

At present Derek can go for a fixed rate mortgage or an adjustable rate mortgage (ARM).

In the fixed rate mortgage, his monthly payments consisting of interest and principal amount would remain fixed throughout the life of the loan.

In ARM, Derek can take the advantage of market conditions in case the interest rate goes down in the market. However if the market interest goes up, Derek will be at a disadvantaged situation.