One of the more common questions we receive from readers about car finance is regarding a balloon payment. In many cases it seems that consumers eager to buy a car sign on for a financing agreement that they do not fully understand.
When we talk about balloon payments (also called residual payments), this refers to a portion of the selling price that is payable at the end of the agreement.
Listen to Maya and Mapalo Makhu discussing this topic on the My Money, My Lifestyle podcast.
Many car financing plans offer this option as it allows you to pay a lower monthly instalment. However, the full balance of that balloon payment must be paid whether it is at the end of the agreement or when you decide to settle your vehicle finance loan. Taking a balloon payment also increases the total cost of the car finance.
For example, you find a car that you really like for R500 000. However, the monthly instalment over five years is R11 400. You cannot afford this, so the dealer suggests that you take a 30% balloon payment option.
This means that R150 000 is put aside to be paid at the end of the agreement and your monthly instalment is calculated on the remaining R350 000
This drops your monthly repayment to R9 700. So now the car becomes “affordable”. What people do not realise is that at the end of the five-year period they still owe the bank R150 000 and that the total cost of the loan is higher.
If you don’t opt for a balloon payment, over five years you pay R684 000 for the car. With a balloon payment of R150 000, you pay R582 000 in monthly instalments plus the R150 000 at the end of the period – a total of R732 000, which is R48 000 more than the total without the balloon payment.
What happens when the balloon payment is due?
Most banks will notify you 90 days before the balloon amount is due to give you time to consider your options. You generally have three choices:
- Pay the full balloon amount: This assumes that you have R150 000 available to settle the amount.
- Refinance the balloon amount: This is a new agreement and means you must pay for an extra 12, 24, 36 or 48 months depending on the option you choose. The interest rate of this new agreement may also differ from your original agreement.
- Sell or trade in the vehicle at a vehicle dealership and settle the outstanding amount: If you decide to sell your car through a dealership, the dealer will first settle the outstanding amount which includes the balloon payment before paying the balance to you. If the amount is too little to cover the outstanding amount, you will have to settle it or refinance the amount. Even if you sell your vehicle privately you must settle the balloon payment. This option could however leave you stranded without a vehicle.
You could trade your vehicle in at a dealership and replace it with another vehicle. The trade-in value will then be used to cover the outstanding amount which includes the balloon payment. The dealership will pay the outstanding amount directly to the bank as part of the process. If the trade-in value does not cover your outstanding amount, you must either settle the outstanding amount or refinance it.
How can I pay off my balloon payment?
According to the Motor Finance Corporation, even though the balloon payment is used to reduce your monthly instalments, it remains part of your finance agreement. This means that when you request a settlement amount on your vehicle the balloon amount is included in the calculation of the settlement amount. Should you decide to settle your vehicle before the finance term is over, you will still have to pay the balloon amount as it formed part of your original agreement.
Some people think that because they have paid in extra each month to their car repayments this has gone towards settling the total debt. They come in for a surprise when they discover they still owe the full balloon payment. It is important to note that unless you inform the bank, the additional car repayments will not be allocated to your balloon payment and will only be used to reduce the debt with the monthly instalment.
The best way to lower your balloon payment is to inform the bank that the additional funds you are paying must be used to reduce the balloon amount. Alternatively, you could open a savings or investment account to start saving towards the settlement of the balloon payment at the end of the contract.
This article first appeared in City Press.