Balloon Loan or ARM

You have studied the balloon loan and adjustable rate mortgage. Whic is the best for you.  the The balloon is the simpler instrument of the two. The word "balloon" means that there is a balance at the end of the term that must be repaid

Unless you come into a sudden bequest, the balloon at the end of 5 years must be repaid with the proceeds of a new loan, and you will pay some settlement costs in the process. In contrast, the interest rate on a 5-year ARM resets using a mechanical rate adjustment procedure. This procedure is spelled out in the original contract, which remains in force, so there are no added settlement costs. This is an advantage of an ARM but only if the ARM is not refinanced.

A more important advantage of the ARM is that the initial rate is generally lower than the rate on a balloon with a comparable term. This is the case with the loans offered to you. If you sell your house or refinance within 5 years, you clearly do better with the ARM.

A third important advantage of the ARM is that it provides valuable protection against a future interest rate explosion, which is unlikely but could happen.

The drawback of the ARM is that, in the absence of an interest rate explosion, the rate will reset substantially above the balloon rate.

The low initial rate on the ARM is a "teaser" designed to produce much higher rates down the road. 

The ARM was clearly the better choice because it had a lower rate and lower risk. However, the market has eliminated this anomaly.  A 5-year balloon now has a lower rate than a 5/1 ARM, but it continues to have greater risk in a rising rate environment.  This makes the choice more difficult.

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