How does a balloon mortgage work?

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A balloon mortgage is a short-term, fixed rate home loan with fixed monthly payments for a set number of years (usually 5-10) followed by a final payment of the principal.
Payments are usually lower with a balloon mortgage because only the interest is paid each month. For example, borrowing $10,000 in a balloon mortgage means that a large payment is due in one lump sum at the end of the term.
Note that if you cannot make the final payment or refinance the amount, you can lose your home.  
The reason for the "balloon" payment is due to a difference between the repayment term (time until maturity) of loan and the actual payment amortization (repayment plan).
With regular financing, 30-year mortgages will have a 30-year amortization (repayment plan) and a 15-year mortgage will have a 15-year amortization. With ballooon finanicng, the loan is frequently due (term) in 15 years, but the payment amortization is for a 30-year repayment. Consequently, at the maturity of the loan in 15-years the debt will not have been repaid, resulting in the last payment being significantly higher.
The benefit for this type of financing is that the borrowers have a low monthly payment. The downside is that the loan usually must be refinanced before the last payment is due (as most people do not have enough to cover such a high lump sum).  
This type of financing has put a lot of people in the situation that they have bought more home than they can afford and believe they are paying it off by making a low monthly payment. Meanwhile, when they cannot prove enough equity or if their future situation does not allow them to refinance, they end up as one of the very many who are being foreclosed upon.
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