In your research on home loans, you may have come across the term “balloon payment.” This usually refers to a large lump sum that is due after a certain period of time on a loan, and is part of the loan agreement. It usually appears on smaller second mortgages that are expected to be paid off more quickly. How exactly does a balloon payment work? It's relatively simple.

• Smaller Monthly Payments

When you take out a second mortgage or select an 80/20 loan as your main mortgage plan, that smaller mortgage is usually spread out over a shorter period of time. These mortgages are often 15 year loans rather than the standard 30 years you see on a larger mortgage. In many cases, there is a caveat to the 15 year loan that makes it somewhat less than a true 15 year loan. This is where the balloon payment comes in.

In order to make the monthly payments lower, the loan is spread out over 15 years-meaning you make the payments as though you were going to take 15 years to pay it off. However, at the ten year mark you are required to pay off the remaining balance of the loan. This is the balloon payment. For ten years, you make payments at the 15 year rate, but for that privilege you have to pay off the rest of the loan at ten years.

• Why A Balloon Payment?

If you were to pay off the same amount of money in ten years' time, the monthly payment would be much higher. In many cases this would make the loan unaffordable. It may seem counter-intuitive to have to pay a large lump sum before the end of the loan, but the expectation in this case is that you will refinance the home before that time. In most cases, ten years is enough time to see some equity built in the home, which will allow you to refinance at a better rate and get rid of the second mortgage altogether.

Balloon payments may sound a bit frightening at first, but the reality is that few homeowners ever actually have to pay them. They can make it easier to afford your monthly payments and get the loan you need for the home you want.