Sometimes the refinance rate is pegged to whatever the rate is when the loan comes due. The agreement could also hinge on the homeowner's payment history. If the homeowner has missed payments, or has been late too many times, the lender might have the right to demand a complete pay-off or a higher interest rate on the refinancing. Of course, the homeowner can always look for another lender to refinance the home. All the borrower pays is the monthly interest.
Nothing is applied to reducing the principal.
When the loan comes due, the homeowner has to come up with the total loan. Some people take out this sort of loan on the assumption that the value of the home will climb high enough to cover all of their moving and sales costs, and still leave them with a profit. While real estate prices traditionally climb, home values in even traditionally high-priced areas have been known to dip or go into slumps. Some of these slumps can last for years. If you are interested in a balloon loan, you'll have to shop around for one.