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Beware the Pop of Balloon Payments

Author: Compare Guru
Date: 2014-06-02
As cash-strapped consumers shop around for attractive vehicle finance options, they could increasingly turn to balloon payments as a way to try and balance their budgets.
JOHANNESBURG – As cash-strapped consumers shop around for attractive vehicle finance options, they could increasingly turn to balloon payments as a way to try and balance their budgets. Up until late last year, car buyers have enjoyed low interest rates, extremely low vehicle price inflation, extended finance periods and an incredibly competitive market, all uniting into reducing monthly car instalments and improving affordability. But with especially new car price increases now outpacing official consumer price inflation (CPI), average vehicle finance periods already close to 72 months and expectations of interest rate hikes to come, the avenues to improved affordability are limited. This could intensify the temptation to choose a balloon or residual payment (an inflated payment at the end of a vehicle finance contract) and reduce monthly instalments. One could also expect that manufacturers, importers and automotive retailers would increasingly design deals to improve monthly affordability. A quick glance at advertisements for vehicle finance in the June edition of a leading automotive magazine shows that all ads include balloon payments options, ranging between 25% and 60%. What the data shows Thus far, financing trends have indicated varying appetites for the balloon payment option. Wessel Steffens, head of Absa Vehicle and Asset Finance, says the percentage of vehicle finance applications with a balloon payment has steadily risen from 16% in July last year to the current figure of 19%. Applications approved with a balloon payment follow more or less the same trend, he says. The average balloon payment is between 25% and 30%. A growing appetite for residual payments is also visible in WesBank’s book. Rudolf Mahoney, head of research at WesBank, says it has experienced a substantial increase in the number of vehicle finance applications requesting a balloon payment. Since January last year vehicle finance applications approved with a balloon payment have grown 20%. Over the same period the size of the balloon payment has increased in line with inflation at around 6%. Mahoney says the main reason for the increase in vehicle finance with a balloon payment is affordability concerns as a balloon payment reduces a buyer’s monthly instalments. Nicholas Nkosi, head of Vehicle and Asset Finance Personal at Standard Bank, says 15% of the total applications received for vehicle finance are with balloon payments. He did not want to divulge statistics around the percentage of applications approved with a balloon payment. Nkosi says although applications for vehicle finance with a balloon payment have been fairly stable, they do anticipate that more and more people will start looking at the option as a means to manage their cash-flow. Impact While choosing a balloon payment will reduce monthly payments, consumers should also understand the impact and the potential risks involved. The below graphs highlight the effect of various types of financing options for a vehicle of R200 000 financed over 72 months. While the actual breakeven points displayed in the graphs are not that important as it will differ depending on factors such as the interest rate offered by the finance institution and the actual trade-in value of the model – the trend is clear. A balloon payment delays the point in the finance period where the outstanding loan amount will be equal to the trade-in value of the vehicle (the break-even point). This means that some customers might find themselves having to pay in an additional amount on their loan, should they trade in their vehicle before the break-even point. In some instances this break-even point might only be reached a year after the average trade-in term of around three years. Steffens says the downside of a balloon payment is that it is interest expensive. It essentially means that some of the outstanding capital is transferred to the end of the agreement and interest would be calculated on a higher outstanding capital amount. He says customers should note that it could be difficult to trade out of the vehicle in the early part of the agreement as the capital redemption is slowed by the balloon payment. It is really important that customers who don’t pay deposits or who choose a balloon payment consider taking an insurance product that covers the gap between the value of the vehicle and the insured amount. Most institutions offer a product called extended cover or top-up that will protect customers in these instances. Nkosi says it is essential for customers to understand the impact of a balloon payment. In some cases buyers will take ownership of the vehicle after paying the balloon, while in other cases – such as vehicle rental agreements – they would just hand back the vehicle without paying the residual. The handful of people who do not choose to trade in their vehicle at the end of the finance term but to settle the balloon payment, should ensure that their cash-flow allows for such a disbursement. This article was first published on MoneyWeb:

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