Car loan balloon payments – what are they?

ALASDAIR DUNCAN
If you’re in the market for a car loan, you may have seen the term “balloon payment” floating about. Let’s take a look at what it means and how it could affect your loan repayments.

We’ll also take a look at some of the potential benefits and drawbacks of this type of loan setup. Questions you may have about car loan balloon payments include:

What is a balloon payment?

A balloon payment on a car loan is a lump sum of money you pay to your lender, generally at the end of your car loan. Its unusual name comes from the fact that a balloon payment can be noticeably large or ‘inflated’ compared to the rest of your loan repayments. However, on the positive side, this can allow you to reduce your monthly payments during the course of the loan.

Generally speaking car loans with balloon payments are most commonly offered through dealer finance and from non-bank lenders, and the payment is normally set at a percentage of the total loan amount. The size of the lump sum – i.e. the percentage of the total loan amount it comprises – may be something you can negotiate with your lender.

Benefits of car loan with balloon payment
A balloon payment can reduce your monthly car payments. Source: Tanasan Sungkaew/Shutterstock.com.

Are there any potential benefits to choosing a car loan with a balloon payment?

If you and your lender agree on a balloon payment at the end of your loan, you could end up spending less on monthly repayments. We considered what your repayments might be on a secured car loan of $20,000, with or without a 30% balloon payment, based on a hypothetical $20,000 secured car loan taken out over five years with the current average application fee and interest rate from Canstar’s database at the time of writing.

With a balloon payment:

Loan amount: $20,000
Interest rate: 7.48%
Application fee: $228
Loan term: 5 years
Balloon payment: $6,000
Monthly repayment: $318
Interest cost (life of loan): $5,068
Total loan cost (excluding loan amount): $5,296

Without a balloon payment:

Loan amount: $20,000
Interest rate: 7.48%
Application fee: $228
Loan term: 5 years
Balloon payment:
Monthly repayment: $401
Interest cost (life of loan): $4,034
Total loan cost (excluding loan amount): $4,262

The information in the above tables is based on research carried out by Canstar and is current as of 27/05/2021. The interest rate and application fee are based on secured car loans available on Canstar’s database for new car purchases, with a loan amount of $20,000 and a term of five years. The balloon payment is assumed to be 30% of the loan amount, paid at the end of the loan. The calculations assume that an application fee of $228 is paid upfront.

Based on the example above, Canstar research shows that with a balloon payment of $6,000 on a hypothetical loan of $20,000, the monthly repayments would be almost $83 less than a comparable loan with no balloon payment.

However, while a borrower’s monthly repayments would be lower with a balloon payment in this scenario,the overall cost of their loan would actually be higher. Our hypothetical example above shows that, with the balloon payment, a borrower would end up paying approximately $1,034 more over the lifetime of the loan with the balloon payment.

Bear in mind, though, that this is just an example and is not based on real products. The exact amount you can choose as a balloon payment will likely depend on factors such as the car you buy and the dealer you choose.

What are some disadvantages of balloon payments?

Including a balloon payment, as the example above suggests, can often bloat your loan and make it costlier in the long run, because it will increase the amount of interest you pay over the course of the loan. The tradeoff of lower monthly repayments is that you will be paying off less of the amount you owe each month, meaning that interest will be charged on a larger amount of money (the amount still owing) so over the course of the loan, you will often end up paying more once you factor in the balloon payment.

Including a balloon payment on your loan may work in your favour in some instances, but it requires careful planning and isn’t necessarily suited to everyone. If you don’t have the money handy to meet the lump sum payment when the loan term is up, you could find yourself in significant financial trouble.

What happens when the loan term is up?

When the term of the car loan ends, this is normally when you’ll have to pay off the balloon payment to your lender. If you can’t afford to pay the full amount in cash, you may need to sell your vehicle to be able to do so. Selling the vehicle may be a suitable option if you’re looking to refinance and buy a newer model anyway. However, it could be worth planning ahead before you take out your loan to try to ensure the resale value of your vehicle will be more than the cost of your balloon payment, or else you could find yourself with a shortfall to meet.

Who is most likely to benefit from balloon payments?

From a borrower’s perspective, balloon payments are often used by small businesses and sole traders who are looking to free up cash flow and aren’t put off by the potentially higher overall costs associated with balloon payments. They may also suit people who want to upgrade their vehicle after a few years and so don’t mind selling it at the end of the loan term in order to make the balloon payment.

What’s the difference between residual payments and a balloon payment?

You may come across both of these terms while comparing loans or other car financing options. Both refer to paying a lump sum at the end of a car loan, but they serve different purposes. Residual payments are typically used on car leases, rather than loans. The size of the payment is calculated based on the forecast final value of the car at the end of the loan.

Balloon payments, on the other hand, are based on a fixed percentage of the loan and, as a general rule, are not impacted by how much the car is worth at the end of the loan.

What other factors should I consider?

There’s plenty more to think about when it comes to taking out a car loan. For instance, you’ll also need to decide whether to get a fixed rate or variable rate loan, and whether you should obtain finance through a dealer, from a bank or from the peer-to-peer lending market. There can be advantages and disadvantages to each option, so it could be worth taking the time to do your research before committing one way or another.

 

Original author Evan Schwarten, updated by Alasdair Duncan. Cover image source: Billion Photos/Shutterstock.com


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