A balloon mortgage is a loan that is issued with a low fixed interest rate for an initial period, much like an ARM. Usually that period is five or seven years. At the end of that period, the borrower must pay off the loan in full (the "balloon" payment). Unless the borrower has received an inheritance or done exceptionally well in Las Vegas, he/she will be forced to refinance the loan.
Some balloon mortgages come with "reset" clauses that provide for the original lender to reset the loan terms so that the loan is fully paid off in the remaining twenty three to twenty five years. The interest rate that is applied is the prevailing rate at the time. If there has been a precipitous rise in interest rates, the borrower is going to be stuck with a costly loan. For the initial period however, the interest rates on a balloon mortgage are usually a little lower than a comparable 5/1 or 7/1 ARM.
Most people that take out balloon mortgages assume that they'll be moving within the seven year period, or that they will be eligible for a more attractive loan at the end of the seven year period. Once again, individuals in this position are assuming either that their household income will have improved; that a loan with low interest rates will be available; or that they will be in a position to take advantage of increased home valuation and sell the property at a profit.
Otherwise, a balloon mortgage without a reset clause can be costly. Refinancing an entire mortgage is an expensive proposition, with closing costs in the thousands of dollars. The advantage of a balloon loan with a reset is that the loan payment will remain constant for the remaining life of the mortgage. The disadvantage is that an upward shift in interest rates may make refinancing a necessity - into an ARM that will help keep the monthly payment manageable but will lead to further uncertainty.
Refinancing requires a decent credit record in order to get a decent loan. The advantage of an ARM over a balloon payment is its thirty year tenure. The lender is stuck with a borrower who makes erratic payments. A balloon with a reset clause can be at the option of the lender, who may make the decision based on the first five or seven years of payment performance.