Understanding balloon payments on vehicles so they don’t blow up in your face

Balloons normally conjure up images of birthday parties, happy times, and harmless fun. A balloon payment, on the other hand, can potentially cost you a lot of money and destroy long term wealth. It is critically important to understand what a balloon payment is, how it works and the potential consequences of taking a balloon payment on your vehicle loan.

The aim of a balloon payment is to make the monthly repayments on a vehicle more affordable for consumers. You can think of a balloon payment as a lump sum that is payable at the end of your loan term.

Illustrating by way of an example: suppose two brothers – Smart and Lazy - buy the identical car – costing them R400 000 each*. Smart and Lazy both take out vehicle finance, but Lazy has decided to opt for a balloon payment of 20% (or R80 000). Smart’s monthly repayments over the 5-year period will be R8 500, while Lazy only pays R7 500.

Lazy feels pretty chuffed with himself, as he has R1 000 extra to spend every month. At the end of the 5-year term, however, Smart will owe nothing on his car, while Lazy will still owe the balloon payment of R80 000.

In summary, Lazy will have paid approximately R18 000 more for the exact same car as his brother:

Smart = Total payment is R509 929.00 (total interest = R109 929.00)

Lazy = Total payment is R527 943.00 (total interest = R127 943.00)

There is more to consider when it comes to a balloon payment; let’s assume Lazy does not have R80 000 available to settle his balloon payment at the end of the 5-year term. His bank graciously offers to extend his loan for another 3 years. This will, however cost him R2 700 per month – meaning he has paid almost R625 000 on a car that cost R400 000 8 years ago.

The real gut punch for Lazy, however, comes when he decides to sell his car after finally settling his debts. After 8 years of depreciation, his car is now only worth R170 000 – which means he effectively lost R455 000 over the 8-year period.

How to pop the balloon

There is, however, hope for Lazy and people who find themselves in a similar situation. If you currently have a balloon payment, the most-effective ways of popping the balloon are to follow one of the following tactics:

Use any surplus funds that you might have to settle your debts quicker.Open a savings account to save up for when the balloon payment becomes due.

If you are in the market for a new vehicle, avoid balloon payments as far as possible. It is also smart to try to save up for a healthy deposit. It is crucial to only buy what you can afford. Generally, a vehicle is a depreciating asset. This effectively means you are borrowing money to fund something whose value goes down as soon as you drive it off the showroom floor.

To better understand vehicle finance and balloon payments, it is recommended that you talk to a Certified Financial Planner who will be able to explain the different options available to you in a simple and clear manner.

References:

*. Assumptions: Interest: 10% per annum, 5-year term, Purchase Price of R400 000.00

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Author: Johann Rossouw, Associate Financial Planner at Fiscal Private Client Services.

Johann holds a BCom (Investment Management) degree, Postgraduate diploma (Financial Planning) and a Certificate in Investment Performance Measurement (CIPM®). Johann is a CERTIFIED FINANCIAL PLANNER ® and has a keen interest in personal finance and how financial markets affect our everyday lives.