When considering buying a new or second-hand vehicle, you may be tempted by the offer of a “balloon payment”. That means that your monthly car repayments are reduced, then, at the end of the term, you have to pay in a large lump sum to complete the purchase of the vehicle. This is helpful in the short term because it reduces your month-to-month expenses, but when you near the end of the repayment term, well, things get complicated.
We spoke to Ghana Msibi, executive head of Sales and Marketing at Wesbank, about the ins and outs of balloon payments, when and how they can work for you, and when they absolutely can’t.
How does a balloon payment affect your repayments?
Balloon payments are usually between 5% and 60% of the total purchase price and can be structured for the finance term of between 12 and 72 months.
Ghana gives the following example:
Buying a car with no balloon payment
Purchase price: R200 000
Repayments calculated on: R200 000
Monthly repayment with 12% interest over 60 months: R4544.75
Total amount payable over term: R272 684.98
Amount owed at end of term: R0
Buying a car with 30% balloon payment
Purchase price: R200 000
Repayments calculated on: R140 000
Monthly repayment with 12% interest over 60 months: R3810.08
Total amount payable over term: R228 604.97
Amount owed at end of term: R60 000
When does a car purchase qualify for a balloon payment?
Not every transaction qualifies for a balloon payment. “The older the car, the smaller the balloon amount that can be added to the deal,” Ghana explains. “In other words, newer cars will qualify for larger balloons. It’s all relative to what the estimated future value of the car will be at the end of the contract when the balloon becomes payable.”
There are three relevant factors that will be considered:
- The age of the car at purchase - the newer the car, the larger the balloon payment can be
- The value of the car at purchase - it cannot be overpriced
- The credit rating of the buyer - the better their credit record, the more easily they will qualify for a balloon payment.
What are the risks of a balloon payment?
If you are buying a car with a balloon payment in place, you will benefit from the reduction in your monthly repayments but will also be reducing the loan by less than if you were paying the full repayment each month. This means that the rate at which the loan is repaid is effectively slowed down.
Save enough money each month to be able to pay the final lump sum at the end of the term.
“It’s important for buyers to save enough money each month to be able to pay the final lump sum at the end of the term if they want to own the vehicle,” says Ghana. “Alternatively, they can either refinance the outstanding amount, or trade the vehicle in and immediately re-enter another finance contract on another car.”
He says that his finance team notes that some buyers – especially those with longer term contracts – forget about the upcoming balloon payment and are faced with uncomfortable debt at exactly the point when they expected to take ownership of the vehicle. “Six years is a long time and it can be easy to forget about the finance arrangements agreed to at the very start of a term.”
Are there any benefits to a balloon payment?
Balloon payments are best suited to buyers who regularly buy new cars, rather than paying off a car and keeping it. These buyers enjoy the reduced monthly repayments, then sell the car before the balloon payment becomes owing, entering into new terms on their next vehicle. Ghana says that the majority of customers never reach the end of the contract when the balloon payment is due because most vehicles are traded in between months 30 and 45. Ideally, the vehicle should be traded in when the outstanding loan amount owed to the bank is equal to the vehicle’s trade-in value, which is affected by the age and mileage on the car. This is called the “breakeven point”. Trading in the vehicle at the breakeven point means that the buyer won’t have to pay in any funds to settle the loan.
“This type of car finance structure should really only be used by experienced car buyers and not first-time buyers,” says Ghana. Because of the complexity of this structure, he recommends only accepting a balloon payment from a reputable car dealership with qualified, registered finance and insurance consultants who will perform a thorough needs analysis and provide the correct advice.
The bottom line
While balloon payments might seem very appealing in the short term, you should only enter into this kind of arrangement if you know what you are doing and have a plan for dealing with the implications of the lump sum payment at the end. If you are simply buying a car for the long term, with a view to paying it off completely, it makes no sense to reduce your monthly repayments while at the same time, saving towards paying off your lump sum.