The risks and benefits of balloon payments in car financing

If you’re considering choosing a balloon payment when financing a new car, you’re not alone. South African banks report that as many as a third of car loan customers are choosing the maximum balloon payment to reduce their monthly repayments. However, it’s wise to consider the long-term impact before committing to a balloon payment.

Balloon payments have become increasingly popular in South Africa due to the rising costs of living, including the higher costs of car purchases and ownership. However, many consumers go for a balloon payment without understanding that they could get caught in a debt trap four or five years down the line.

Lowering your monthly repayments can help you to stretch your salary a bit further and potentially afford a better car. But the lump sum at the end of the loan term is the sting in the tail. While a balloon payment can be a useful financial planning tool, all too many people find that they struggle to afford the final repayment.

Balloon payments in practice

A balloon payment is a large amount that you agree to repay at the end of your car finance term, usually between 20% and 35% of the vehicle’s value, with 40% being the maximum most banks would allow. During the term, you pay lower monthly instalments, but it’s because you're not paying off the full loan, just a portion of it. 

This might feel like a win, but consider the total costs of buying a R500,000 car on a six-year loan (assuming no deposit and an interest rate of 10.5%):

When the balloon payment is due, your options will be to:

• Pay it off in cash and own the car outright.
• Refinance the outstanding balloon payment. You’ll enter a new loan agreement and face another few years of making monthly payments and interest charges. You will need to qualify for financing to take this option.
• Extend the loan term. Some lenders might allow you to stretch out your repayment period further, though this could mean paying even more interest costs. Again, this is only possible if you’re creditworthy.
• Sell or trade in your car, leaving you without an asset after forking out cash for months. But remember, you’ll still need to settle the balloon payment.

Risks of balloon payments

These numbers and options make the significant risks and costs of balloon payments clear. The monthly benefit is very small compared to the future risk you’re taking: 

• You face significant financial risk because you’ll either need to have cash to pay the balloon payment at the end, or you will need to finance it.
• The bigger the balloon payment, the higher the interest you pay over the full term of the loan.
• After depreciation, your car might not be worth as much as the balloon payment at the end of the loan.
• You may never own a car outright if you get caught in a loop of refinancing via a balloon payment plan every five or six years.
• If you want to exit the loan early, you need to be prepared for early settlement penalties and the outstanding balloon payment.
• Even worse, if your car is stolen or written off in an accident, you will be forced into an early settlement and will need to pay a massive shortfall.
• If you can’t afford the final payment, you could face consequences such as repossession of the car under the National Credit Act.

In theory, a balloon payment gives you the option to pay a large cash amount at the end of your finance term, and then you can keep the car. But the reality is that most people don't have that kind of cash lying around, so they end up having to sell the car. And if the car’s value is less than the outstanding balloon amount, it becomes a very serious problem – one that many people are unfortunately facing.

Do balloon payments ever make sense?

Despite the costs and risks, there are some instances where balloon payments can be a helpful tool in your financial planning:

• You like to trade your car in for a new model every few years and are confident you can afford the balloon payment when it's due.
• You can realistically expect your income and savings to increase over the loan term.
• You want a reliable new car with a warranty, rather than risking potentially higher and unpredictable maintenance costs with an older one.
• You are paying for the car through a business and can claim tax deductions on depreciation, interest, fuel, maintenance, and potentially the balloon payment to help with cash flow.
• You don’t anticipate needing to exit the loan early and are committed to keeping the car for the full loan term.

Guaranteed Future Value vs. traditional balloon payments

 If you’re still considering a balloon payment, a Guaranteed Future Value (GFV) finance option could be a safer alternative. GFV agreements add a layer of financial security by guaranteeing the value of your car at the end of the finance term, regardless of how much it has depreciated. This guaranteed amount functions as your balloon payment (also known as the “optional final payment”) and is agreed upon upfront. When the finance term ends, you’ll have three choices: Make the final payment and keep the car, trade it in for a new car, or give the car back with nothing more to pay, even if its actual market value is lower than the GFV. As such, it offers peace of mind and avoids the burden of being left with a car that’s worth less than the lump sum you still owe.

I warn against using balloon payments to buy a car you can’t actually afford in the long term. Rather, put down a larger deposit or choose a more affordable car. Remember, a more expensive car will also have higher maintenance and insurance costs. While it can make sense in some circumstances, the downside of a balloon payment is very seldom worth the benefit.

* North is a co-founder of the car and home insurance platform, Naked.

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