Balloon loans may be hard to understand at first, but the principle is relatively simple. With a balloon loan, you don't pay off the loan gradually at a steady rate of payment each month until the period is up (usually 15 or 30 years with most FRMs or ARMs). Instead, balloon loans work much like an FRM for 5 or 7 years, with the borrower making regular payments each month, but then something very different happens at the end of the 5 or 7 year period. At the end of a balloon loan period, the borrower must pay off the remainder of the loan in full. Unless the borrower has come into a large sum of money, this usually means that they will need to refinance at this point.
Let's say you take out a $100,000 5-year balloon loan at 5%. For those five years, your monthly payment would be the same as if you had taken out a 30-year FRM. But at the end of that five year period, you'll be expected to pay the remaining balance on the balloon loan. This large payment at the end of the period is known as the "balloon," because it is usually extremely large when compared to the monthly payment. In the above example, your monthly payment would be $536.82 for both the 5-year balloon and the 30-year FRM. While you would pay this every month for 30-years in order to pay off (fully amortize) the FRM loan, this payment would only continue for 5 years on the balloon loan. At the end of the five years, you'd have to pay the entire remaining balance, over $80,000, all at once. The only other recourse would be to refinance. Balloon calculator here.
The advantages of a balloon loan is that they usually have a lower rate than a comparable ARMs initial period. Additionally, balloon loans are usually simpler. You should still only take this option if you plan on moving out before having to pay the balloon. If you don't plan on moving out, then just take an ARM instead. Make sure you are aware of all of your available mortgage options before choosing.