In addition to the time frame and interest rate, some mortgages have features to help reduce your monthly payment or interest rate. Balloon payments and prepayment penalties are features that can be incorporated into all kinds of mortgage products, including fixed-rate mortgages and adjustable-rate mortgages.

Balloon Payments

Both fixed-rate and adjustable rate mortgages can include a balloon payment. A balloon payment requires you to pay off the entire outstanding amount in a lump sum after a certain period has passed. If you can't pay the entire amount when the balloon payment is due, you have to refinance the loan or sell your house.

Balloon payments can work for you if you understand the terms. They can be packaged with a loan that has a lower interest rate or they can be used to lower the amount of your monthly payment. Or, you might be sure you will be moving (or refinancing) before the balloon payment is due. For example, If you know you’ll want to move or refinance your mortgage after 10 years and your balloon payment comes in year 15, you won’t have to worry about paying the large payment off.

Most people see balloon payments as a risky option and avoid them. You have to be absolutely sure that when the balloon payment comes due, you will have the funds to pay it off. Otherwise, this mortgage feature may not be right for you.

Prepayment Penalties

A prepayment penalty is a charge for paying off your loan early. For example, if your loan carries a prepayment penalty and you pay off or refinance your loan within the first 3 years, you’ll have to pay a penalty. Prepayment penalties can be used by lenders to offer lower initial interest rates. In exchange you agree to hold the loan for a specified period of time (maybe 2 or 3 years).

Traditional first mortgage products tend to not have prepayment penalties, but second mortgages, sub-prime mortgages and newer mortgage types like adjustable-rate mortgages (ARMs) or interest-only loans may include them. If you plan on selling or refinancing your home early, or think you may qualify for a lower interest rate in the next several years, you can avoid significant costs if you choose a loan without prepayment penalties.