Buying a Car with a Balloon Payment Feature

If you’re considering a balloon payment when financing a new vehicle, you’re not alone. South African banks report that around a third of car loan customers choose the maximum balloon payment to lessen their monthly financial burden. However, it’s essential to assess the long-term impacts before settling on a balloon payment.

Balloon payments are becoming increasingly popular in South Africa due to rising living costs, including elevated vehicle purchase and upkeep expenses. Yet, many consumers opt for a balloon payment without realizing they could be trapped in a cycle of debt four or five years later.

Lowering your monthly payments might enable you to stretch your salary and potentially afford a nicer vehicle. Nevertheless, the significant amount due at the end of the loan term presents a major obstacle. While a balloon payment can act as a budgeting tool, many people struggle to make the final payment.

Understanding Balloon Payments

A balloon payment is a large sum you agree to pay at the end of your car financing term—usually between 20% to 35% of the vehicle’s value, with 40% being the maximum allowed by most banks. During the term, you pay reduced monthly installments because you’re only repaying part of the loan.

This might seem like a win, but consider the overall cost of acquiring a R500,000 vehicle over a six-year loan (assuming no deposit and an interest rate of 10.5%):

	Monthly Repayment	Lump Sum at End (Balloon Payment)	Total Cost of Credit
No Balloon	R9 481	R0	R682 000
With a 20% Balloon Payment	R8 478	R100 000	R710 000
With a 40% Balloon Payment	R7 475	R200 000	R738 000
R500 000 car, assuming 72-month term, no deposit, 10.5% interest rate

When the balloon payment becomes due, your options include:

• Paying it off in cash to fully own the car.
• Refinancing the remaining balloon payment. This means entering a new loan agreement, resulting in additional years of monthly payments and interest charges, requiring qualification for financing.
• Extending the loan term. Some lenders might allow you to prolong your repayment period, although this could lead to increased interest costs and depends on your creditworthiness.
• Selling or trading in your vehicle, which leaves you without an asset after many months of payments—remember, you’ll still need to cover the balloon payment.

Risks Associated with Balloon Payments

The figures and options outlined here underscore the significant risks and costs tied to balloon payments. The monthly savings are relatively minor compared to the future risks you may encounter:

• You are exposed to serious financial risk as you’ll either need cash to settle the balloon payment at maturity or need to finance it.
• The greater the balloon payment, the higher the total interest paid over the entire loan term.
• After depreciation, your car may not retain enough value to cover the balloon payment by the end of the loan.
• You might never fully own the vehicle if you find yourself continually refinancing through a balloon payment plan every five or six years.
• If you want to exit the loan early, expect to face early settlement penalties along with the outstanding balloon payment.
• Additionally, if your vehicle is stolen or totaled, you’ll be forced into an early settlement and face a substantial shortfall.
• If you can’t manage the final payment, there may be repercussions, including potential car repossession under the National Credit Act.

In theory, a balloon payment allows you the chance to make a large cash payment at the end of your financing term and keep the vehicle. However, the reality is that most people don’t have that cash readily available, which often leads them to sell the car. If the car’s value is less than the outstanding balloon payment, it creates a major issue that many individuals are unfortunately facing.

When Do Balloon Payments Make Sense?

Despite the associated risks and costs, there are circumstances where balloon payments may be advantageous:

• You prefer to trade in your vehicle for a newer model every few years and are confident you can manage the balloon payment when it becomes due.
• You realistically expect an increase in your income and savings during the financing period.
• You want a dependable new vehicle with a warranty, rather than facing potentially higher maintenance costs with an older car.
• You are financing the vehicle through a business and can take advantage of tax deductions on depreciation, interest, fuel, maintenance, and possibly the balloon payment to assist with your cash flow.
• You don’t plan to terminate the loan early and are committed to keeping the car throughout the loan period.

Guaranteed Future Value vs. Traditional Balloon Payments

If you’re still considering a balloon payment, a guaranteed future value (GFV) finance option might provide a more secure alternative. GFV agreements offer added financial security by guaranteeing the car’s value at the end of the financing term, regardless of its depreciation. This guaranteed amount serves as your balloon payment (or “optional final payment”) and is determined at the start. Upon concluding the finance term, you have three choices: make the final payment and keep the car, trade it in for a new vehicle, or return the car without any further payments due—even if its market value is lower than the GFV. This gives you peace of mind and prevents the issue of having a vehicle worth less than what you owe.

Exercise caution when considering balloon payments for a vehicle you can’t truly afford in the long run. Instead, think about making a larger deposit or choosing a more affordable car. Keep in mind that a more expensive vehicle will also entail higher maintenance and insurance costs. While balloon payments can be beneficial in certain situations, their disadvantages often outweigh the advantages.

Ernest North, co-founder of the car and home insurance platform, Naked.

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