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Balloon Payments – How Do They Work?

Author: Jason Snyman
Date: 2019-05-29
Many car buyers have faced debilitating debt after agreeing to a Balloon Payment loan. How does this work, and how were they caught out?

When negotiating a car loan, an important choice you’ll have to make is whether or not to take a Balloon Payment – or Residual Value – on the loan. These are basically the same thing. Having a Balloon Payment, and the size of it, allows you to pay lower monthly instalments during the first few years, while enjoying a car you wouldn’t otherwise be able to afford. It may sound like a good idea, but there are a number of negative aspects to it. 

Many car buyers have received some unpleasant surprises, and found themselves plunging into completely unmanageable debt, because they didn’t really understand how the pitfalls of Balloon Payments work. You may be able to get the car of your dreams, but really, the sting is in the tail.

What Is A Balloon Payment?

Let’s explain this in the simplest way possible. 

Say you’ve found a car you love, but you can’t realistically afford it right now. It costs, shall we say, around R400 000. So you borrow R400 000 over 5 years from your financier and you elect to have a 25% (R100 000) Balloon Payment on your loan. They put that R100 000 aside and let you pay the remaining R300 000 off. 

Now, your monthly repayments are significantly lower than they would have been if you had no Balloon Payment. Therefore, you can now afford that car you so desire. Except, at the end of that 5 year period, you still owe the bank R100 000, and now, they want all of it at once. 

So you either need to pay that full amount, or roll the amount over into a new loan, or sell the car. Maybe you’ve thought about this, and you’ve somehow been putting money away over the years. Perhaps you plan on getting that R100 000 refinanced, if the bank will approve it. 

This also means that you’ll probably be paying that car off for longer than you’d even care to drive it. Of course, you’re still paying interest on that amount over the full loan term. Depending on the interest rate, you’re likely to be in for quite a shock. 

Getting out of this sort of loan is pretty difficult, as well. It’s not the same as settling a normal vehicle loan. You might be responsible for early termination charges which are stipulated on the contract. 

So, not only do you need to understand how it works, but you also need to take a very close look at any possible penalties.

The Limitations of a Balloon Payment

This could vary, depending on a number of factors. Each financial institution has specific things they look for, which could be anything from the age of the vehicle, your financial profile or the loan term itself. 

Businesses often use the term ‘Residual Value’ to describe the predicted amount an asset might be worth at the end of the line. So, what this means is, if you’re planning on selling the car to settle your Balloon Payment – you’re probably only going to get enough from the sale to cover your debt. 

Nothing extra. 

For example, say your car is valued at R400 000 and it is predicted that it may only be worth R200 000 after 5 years. So, after 5 years the car only retains 50% of its value. Therefore, no bank can grant a Balloon Payment bigger than 50% for a 5 year loan. Due to various risks, of course, the Balloon Payment actually granted will be much lower – the average being 30%. 

For non-ownership residuals or leasing, there are other limiting factors to consider as well. Because a car’s mileage affects its resale value, there’s usually an annual mileage limit, as well. This is typically 15,000 to 25,000 kilometres per year. Should you exceed this limit, because heaven forbid you enjoy driving the car you work so hard for, a cost-per-km penalty could apply. 

Bad news for Brakpan dwellers – you won’t be allowed to modify or upgrade the car in any way, either. Likewise, there may also be restrictions to wear and tear. Any abnormal damages, which further decrease the resale value, could be subject to penalties. 

If you plan on somehow conjuring up the remainder of the money up at the end of the term, and purchase the vehicle, though, that’s another story.

Insurance, and In Closing

The only insurance that will be accepted with a Balloon Payment is comprehensive motor vehicle insurance. 

While Balloon Payment deals might intrigue you, and of course, there’s the opportunity to drive that special car, they’re not always the best solution. It’s important to do thorough research and consider if what you’re doing is wise. 

Instead of facing debilitating debt in 5 years time, perhaps it’s better to keep a monthly budget and live within your means. At least, until the money from that Nigerian Prince who keeps emailing you clears.

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