Final answer:
A balloon mortgage ends with a large lump-sum payment, which became problematic when housing values dropped during the housing bubble, leading to defaults and a financial crisis. The crisis was worsened by ARMs resetting to higher rates that homeowners couldn't pay, causing a freeze in the credit markets.
Step-by-step explanation:
At the end of a balloon mortgage, a financial situation arises where the borrower must make a significant, lump-sum payment to cover the remaining principal balance on the mortgage. This is markedly different from a typical mortgage that is paid off in even, consistent increments over the life of the loan.
In the context of the housing bubble burst, homeowners with balloon mortgages found their homes drastically reduced in value, often below the owed balance. Banks and mortgage companies initially believed this system to be fail-proof, provided the continual rise in home prices. Unfortunately, when the market value of these homes plummeted, borrowers faced mortgages on properties now worth significantly less, leading to widespread defaults and a subsequent financial crisis.
The ballooning of mortgage payments caused by the reset of adjustable-rate mortgages (ARMs) compounded the problem. Homeowners were enticed by low introductory interest rates only to find upon rate adjustment their monthly payments surged, sometimes beyond their ability to pay, leading to further defaults. This scenario led to a drastic reduction in the wealth of the household sector and forced several mortgage lenders into bankruptcy as defaults soared and the value of their asset-backed securities plummeted.
As the financial crisis spread, credit markets froze, making capital inaccessible even to credit-worthy customers and crippling the broader economy.