beware of car residuals

Buying a car? Beware of residuals!

Posted  April 15, 2014

The cost of buying a car has rocketed over the past 20 years. By way of example, let’s look at the classic Golf GTi. A 2litre Golf GTi exec would have cost you R96 800 in 1994. A GTi 1.8 Turbo exec would have cost you R231 600 in 2004. And today, a Golf GTi 2l turbo will cost you R386 000.

High car price inflation means that buyers are becoming more comfortable with longer-term hire purchase contracts, which now stretch to as much as 72 months or six years. Dealerships are also now offering attractive deals where you can buy an expensive car at a lower monthly instalment. How is this possible? Well, you need to read the terms and conditions, which are likely to include a residual value (balloon payment) or a payment holiday.

Residual valuesA residual value or balloon payment is where the bank takes a value (usually 30 to 35% of the sale price) and defers this amount to the end of the loan term. For example, if you buy a car priced at R309 000 with a residual of 30%, then the residual amount works out to R92 700. Your instalments are worked out on the remaining value of R216 300 and at the end of the loan term, you will still owe the bank R92 700.

A balloon payment deferred to the end of your hire-purchase agreement can make your car instalments more affordable. However, the fact that you need a balloon payment or residual value to make the instalments more affordable should immediately alert you to the fact that you are buying a car you cannot afford!

Usually, when you buy a car on a hire-purchase agreement, you own the car at the end of the loan term. If you agree to a residual value, then instead of having paid off the car after six years, you are still responsible for the balloon payment. Residual values typically range between 30% and 35% of the sale price, although some unscrupulous dealers will take these residual values higher just to close a sale. So, six years after you first signed for the car, you then have the choice of refinancing the car to pay off the outstanding residual value (R92 700 in the example above) or trading it in. The value of the car will have depreciated by the time you reach the end of the loan term, so even if you trade it in, the trade-in offer you receive is likely to barely cover the residual value, leaving you nothing for a deposit on a new car.

Payment holidaysYou should also watch out for special offers that include “payment holidays”. For example, the dealer or financing bank may tell you that you can pay instalments for 11 months and not have any car payment for one month every year. This sounds great on paper but in reality, the cost of that 12th month’s instalment is either spread over the other 11 months or the term of your loan is extended to cover it. If it is spread over the other 11 months, it means your instalment would be more affordable if you skipped the payment holiday and spread payments over all 12 months of the year. For example, if your monthly instalment worked out to R2 400 a month and you opted for a payment holiday in December, then the R2 400 instalment for December is simply spread over the rest of the year, pushing your monthly instalment for January to November up to R2 618 a month.  If the term of your loan is extended to make up the difference, then you could wind up paying more interest over the long term. Either way, that payment holiday will cost you more than it’s worth.

Your best option if you are buying a car is to save for a deposit of between 10 to 30% and sign a hire purchase agreement for 54 to 60 months (five years) at the most.

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