Car loans can be expensive, so if you are looking for a way to cut your loan repayments, you might want to opt for car finance with a balloon payment.
This type of loan involves making a lump sum payment at the end of the term, thus saving you money on monthly loan payments. However, before you agree to one, it is important to understand more about this loan feature, how it works and how it differs from residual payments.
What Is a Balloon Payment?
A balloon payment is a one-off lump sum you pay to your lender at the end of the loan term, covering the remaining cost of the car loan. With a balloon payment, you will only need to repay interest on part of the principal throughout the life of the loan, thus reducing monthly instalments in exchange for a bigger payment at the end of term.
The name derives from the fact that the final payment is ‘inflated’ compared to regular loan payments—it is not uncommon for the balloon payment to go up to half of the car’s value.
Car finance with a balloon payment is calculated as a percentage of the overall cost of the car loan. You typically negotiate the amount with the dealer, but payments tend to range from 15% to 50% of the total value of the loan.
The sum you repay monthly will be determined by the amount borrowed for the car loan, the size of the balloon payment, the loan term and the interest rate.
Note: The interest rate is set by the lender which is why it pays to shop around and get the best rates.
How does car finance with a balloon payment work?
Let’s say that you bought a vehicle worth $40,128, the average amount Aussies are willing to spend on a car and took out a loan amount of $50,000 with a loan term of 5 years at an interest rate of 4.9%. You and the lender agree upon a 25% balloon payment or $12,500.
Without a balloon payment, you will be paying $941.27 a month. With a balloon payment, the amount is reduced to $793.38, which means you will save around $147.89 every month. That money could go toward your savings, grocery bills, or mortgage payments.
It is important to note that these savings are just temporary—you will still have to repay the balloon payment of $12,500 in full at the end of the balloon loan on the car.
Continuing with the same example, here is a brief overview of the cost of car loans with and without a balloon payment.
As you can see from the table, while you save $147 every month, you would save $1,443 over the length of the loan with a car loan without a balloon payment.
Note: This is just a hypothetical scenario as the actual amount depends on the terms of your loan, your dealer and the car you choose.
Related reading:When is the best time to buy a car in Australia?
Who offers balloon auto loans?
Usually, car loans with balloon payments are part of dealer finance or non-bank lenders, but they are offered on some car loans as well.
At the moment these are the best providers of car loans with balloon payments. Keep in mind that it is important to shop around before you settle on a lender. Compare quotes and make the best decision for your financial circumstances.
*Loan term: 5 years; amount: $45,000; credit rating; excellent
Pros and cons of a balloon payment loan
The main benefit of a car balloon payment is that you will be required to make lower monthly or weekly loan repayments. Considering that the average two-car household pays about $130 a week in car loan payments, every chance to cut costs (even temporarily) is welcome.
Other benefits include
- Car loans with balloon payments can allow you to buy a more expensive car than you would be able to otherwise afford;It makes it easier to manage loan repayments within household expenses and your budget;The cash you save every month could go towards investments, such as stocks or index funds;It gives you more time to come up with the money for the loan;You can sell off the car at the end of term or trade it in to pay for the remaining cost of the loan.
What about the drawbacks?
- Car loans with balloon payments can be risky—you will end up owing thousands of dollars and in case you cannot make the payment, the vehicle will be repossessed. You probably won’t be able to sell the car for the same amount you bought it, due to depreciation, which means you might not have enough for the balloon paymentThere is no guarantee that you can refinance the loanYou will end up paying more over the long term as you will be paying more in interest. With a standard car loan (both unsecured and secured car loan) you pay interest on the amount you owe which gets smaller and smaller with each monthly repayment. With a balloon on a loan for a car, the remaining cost of the loan doesn’t diminish over time, so you are basically paying interest on a larger amount of money.
Who are balloon payments best for?
Balloon payments are best suited for people who like to change their vehicle every few years or upgrade their car while keeping repayments low and maintaining a healthy cash flow.
As such, they are favoured by small businesses and sole traders who want to minimise monthly expenses and free up cash for investments. Plus, businesses tend to use the car more than consumers, which means that they are ready for a replacement when the loan term is up.
What’s the difference between a balloon and residual payment?
Both balloon and residual payments require the borrower to pay back a lump sum when the loan term is up.
The main difference, though, is that residual payments are used on car leases instead of car loans. The amount you need to repay at the end of term is estimated based on how much the vehicle will be worth when the payment is due. With a balloon payment, you agree to the amount when you take out the loan, i.e. the balloon payment is not affected by how much the car is worth when the loan ends.
What happens if I can’t afford the balloon payment?
At the end of the loan term, you will be required to pay the remaining cost of the loan. There are some instances where you cannot afford to cover the balloon payment. In that case, you can:
1. Refinance your loan
By refinancing you extend your repayment period from one to seven years.
Some lenders will agree to refinance the balloon payment, allowing you to pay it back in instalments rather than a lump sum. However, even if you refinance the car loan with your existing lender, chances are you will be offered higher interest rates on the refinanced amount. Plus the lender will apply the same criteria as with a new loan, which means there is no guarantee that you will be approved.
2. Sell the car
Selling the vehicle is the most popular option—many people sell the car and then apply for a new loan, usually one that has better terms or allows them to buy a newer or more technologically advanced model.
But, as mentioned above, cars depreciate over time, so you are likely to sell the vehicle for less than the original price. If you haven’t saved up enough over the life of the loan to cover the balloon payment, you might end up in financial trouble.
3. Personal loan
If the resale value of the vehicle is lower than the balloon payment, you will have to find another way to cover the gap. Personal loans are a popular choice among Aussies—around 8 million Australians take out a personal loan every year—however, this financing option comes with high-interest rates and could put you more in debt.
4. Trade in the vehicle
Trading the vehicle works more or less like selling the car. The difference is you can buy a new car and have the balloon payment form part of the new vehicle payment. The drawback here is that you will have a limited selection of vehicles to choose from.
Are Car Balloon Payments a Good Idea?
Adding a balloon payment to your car loan has its benefits—you will save on monthly repayment and have more cash on hand to cover living expenses or take advantage of an investment opportunity.
However, you must be aware of the risks involved. Assets like cars depreciate over time which means that if you plan to sell the vehicle to repay the residual amount of the loan, you will be left with a shortfall to cover. What’s more, car balloon loans are likely to cost more over time than a standard car loan.
Finally, there is more involved in taking out a car loan than the balloon payment—you will have to factor in other aspects such as the terms of the loan, the interest rate and the deposit and calculate whether the long-term cost is worth the short-term savings.
Some final tips to avoid the most common balloon car loan danger:
- Don’t opt for a balloon payment on a car loan unless you have savings or a plan on how to repay the lender when the balloon payment is due. Don’t go out of your price range. Just because you don’t have high monthly repayments doesn’t mean you can get comfortable and buy a vehicle you cannot afford. Start saving as soon you take out the loan. If your monthly expenses allow it, put money on the side each month. Try to buy a car model that doesn’t depreciate fast so you can sell it for a good price and repay the balloon payment when the time comes.
1. How big can a balloon payment be?
Balloon payments are usually capped at 50% of the total amount of the loan, so if you want to take out a $40,000 loan, you cannot get a balloon payment higher than $20,000.
2. Can you pay off a balloon payment early?
This depends on the lender, but most will not allow you to pay off the balloon payment before the due date. Some loan providers can be flexible but might charge a penalty fee—you need to discuss these matters with your lender before signing on the dotted line.
3. Can you get an electric car with a balloon payment in Australia?
Yes, if you want to buy an EV and get lower monthly instalments on the loan you could opt for a car loan with a balloon payment.
3. Can I buy a car without a balloon payment?
Yes, you can take out a standard car loan and repay it every month with interest. The loan will be settled with the final monthly payment. In the case of car finance with a balloon payment, the loan will be finalised when you pay the remaining amount (i.e. the balloon payment) in full to the lender.
