What Is A Balloon Payment And Could It Inflate Or Deflate Your Total Car Loan Cost?

3 May 2019

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.

Benefits of car loan with balloon payment
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What is a balloon Payment?

A balloon payment is a lump sum that 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 this option is most commonly offered through dealer finance and from non-bank lenders, and is normally set at a percentage of the total loan. 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.

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

Yes, there may be. As the example below shows, agreeing with your lender that you will make a balloon payment at the end of your loan can often mean you end up spending less on a month-to-month basis on repayments.

Car loan balloon payment example

  With balloon payment Without balloon payment
Loan amount $18,228.77 $18,228.77
Interest rate 10.70% 10.70%
Loan term 5 years 5 years
Balloon payment $5,468.63 (30% of loan amount)
Monthly repayments $327.36 $396.68
Total cost of loan (interest & ongoing fees) $7,061.02 $5,751.88
Total amount to be repaid $25,289.79 $23,980.65
Source: Canstar & MoneySmart Cars – 29/04/2019. Canstar data based on loans available for new car purchases at an average loan amount (based on MoneySmart Cars: $18,049) plus average loan application fee of $179.77, at a reference rate of 10.70%, repaid over a five-year total loan term. Monthly repayments include average fee of $3.08 charged monthly. Balloon payment amount equal to 30% of the original loan size.

In fact,  based on the example above, Canstar Research shows that with a balloon payment your monthly repayments would be almost $70 less than a loan without a balloon payment for the same amount and with the same interest rate, fees and term. However, when you factor in higher interest costs over the life of the loan, in this example, the loan with a balloon payment would cost just over $1,300 more in total. 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.

How about some disadvantages of balloon payments?

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.

You also need to be aware that 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. That’s because for the entire life of the loan, you’re paying interest on the full amount you’ve borrowed, including the lump sum, and only progressively paying down a portion of the debt.

To use the example given above, you’d been paying interest on the full $18,228.77 loan, but your regular repayments would only go towards paying down 70% of that debt, meaning you’d still be left with a bill for 30% of original amount at the end of the loan.

What happens when the loan term is up?

When the term of the loan is up, 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. However, it could be worth planning ahead before you take out your loan to try and 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?

Balloon payments and car loans
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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 can 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. 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.

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