Buying a new car is always exciting, but it sure comes at a high cost! Sometimes more than what we can afford. It’s easy to become emotionally attached to the car and do whatever it takes to be able to afford it, and that’s unfortunately when many are encouraged to use a balloon payment. It does make the monthly repayments more affordable, but what is a balloon payment really?
Buying a car
Buying a car usually starts with a visit to a dealership and test driving cars that are slightly above what we can afford. Of course that’s okay, you can test drive any car you want! But, once reality sets in and you start looking at costs it becomes a whole new story.
Cars are expensive and inevitably it works out to more than expected. But, considering that it’s a big purchase, we like to try to make it work. And of course, we get emotional and feel that we “deserve” the nice car or we fall into the trap of “needing” to replace the car eery 3 – 5 years as that is “what makes financial sense“.
Well, that is a topic for a whole other post. But let’s get it straight, buying a new car every few years makes no financial sense as you inevitably dig yourself deeper into debt.
Sounds harsh I know, but there’s no nice way to say it. LOL
What if buying a car is too expensive?
Once we’ve decided on our dream car, added all the extras, looked at what we want and see that it’s too expensive; what are the options?
Option 1: The best option!
Don’t buy the car! Find a cheaper one. LOL
Option 2: A better plan
Delay the purchase and save up for a larger deposit or potentially even buy a cheaper car for cash. These are good options.
Second-hand cars often have a bad reputation as people feel that the services and maintenance will cost the earth. It is possible to buy a “dud” car but if you work through a reputable dealership and buy a car that is still in good condition, you can get very good vehicles!
Other options (good, but not necessarily the best options)
You can negotiate a lower monthly instalment by opting for a longer period, negotiating a better interest rate or negotiating the purchase price.
You can also opt for fewer of the “add-ons” and “nice to haves”.
Last option, a balloon payment – really not the best decison
A balloon payment will lower the monthly instalments and make the purchase more affordable, and far more tempting. But, the lumpsum that you choose as a balloon payment will be due at the end of the loan term. And, all in all you will pay much more for the car.
What is a balloon payment?
Let’s start off with an example. If you are looking to buy a car for R240,000 over 60 months (that’s 5 years!) at 10.5% interest then your instalment will be: R5,158. (This excludes monthly admin charges, or finance fees and insurances – look at this to save on car insurance though)
See the video below to work out the payments yourself.
Note that the interest rates are currently quite low due to the governments response to the corona pandemic. But don’t be fooled, they will go up again!
With a balloon payment though, you are not paying off the full loan over the 60 months. Let’s say that you opt for a 20% balloon payment (R48,000), that means that you will pay a lower instalment so that after 60 months your outstanding debt will be R48,000.
You will then have to settle that outstanding amount as a lumpsum.
To put in another way, you will take out a loan of R240,000 but by the end of the loan period the outstanding debt will be exactly the amount of the balloon payment. And you then need to settle that immediately.
In the first example, a balloon payment of R48,000 reduces the monthly instalment by R611 but the overall cost of the car is R11,200 more. In fact, you would pay R80k just in interest for the car. That’s a lot of money!
The second example shows a more expensive car and using a balloon payment ends up costing close to R19,000 more! And, the total interest paid is over R130k. But worst off is that you would need R80k cash at the end of the loan agreement.
Related: Save money on your car insurance
How the balloon payments hurts
Imagine paying off your monthly instalment each month for 5 years and then having to come up with a lumpsum of R48,000 (or more) on the spot!
Most people tell themselves that they will save up for this and that it won’t be too bad. Or perhaps they feel that they’ll sell the car and settle it easily.
That unfortunately is seldom the case and the outstanding lumpsum is often covered by further debt. Some people opt for a personal loan (at an interest rate of 20% or more) to pay off the balloon payment (that they have already being paying interest on). Or, they work it into the next cars financing.
Either way, if you finance the balloon payment you end up paying interest on top of interest and really hurt yourself financially!
Is a balloon payment the same as a residual payment?
No! They are similar but also very different and it’s key to understand the difference.
A residual loan agreement is also known as a lease agreement or non-ownership agreement. In this agreement, the dealership will calculate the future value of the car after the loan period (eg 5 years) and you pay the loan off in the same way as a balloon payment. So on your R240,000 car the future value may be R60,000 and for the purpose of calculating the instalments you can see the R60,000 as a balloon payment.
However, after your loan period, you do not own the vehicle!
You can either return it to the dealership or you may purchase it for the current value.
Because you are only leasing the car the dealership will often impose penalties if you clock up too many kilometres, and there will likely be other clauses to look out for.
Many people use a lease agreement to always be able to drive a new and fancy car. But, they never own it.
May sound like a good plan but you’re really wasting your money as you have nothing to show for it after the lease period.
It’s your money
I’ve been told that I sometimes write too “harshly” and if that’s how you feel please realise that I am just passionate about managing my money as best I can, and would love for you to do the same.
Of course not everybody agrees with my views and if using a balloon payment or residual lease works for you then by all means do it! In fact, if driving a fancy car is a priority for you then that is fine.
This is simply an explanation of how it works and to show the calculations behind it.
Related: Should I sell my car?
A readers comments on a balloon payment
An email from Steven
My wife and I bought her a new car when she had just started working and the salesman at the dealership managed to convince us that a balloon payment was a good thing as it would bring the monthly car payment down. Which at the time we thought it was a great idea and went ahead as we had options to refinance or sell the car to settle it later.
When we had a year left of car payments we decided to aggressively save towards paying the balloon payment cash. This after we saw what interest the finance house would be adding for us to refinance the balloon payment.
Thinking about it I would say our experience was a bad one due to the fact we didn’t fully understand the consequences. A couple hundred bucks saved in monthly premiums became a huge lump sum later on.
With what I know now I would always stay away from a balloon payment finance option.
Article reposted with permission from Take charge of your money.