Balloon payment car loans explained

Balloon payment car loans explained
If you want to cut your regular car repayments, consider getting a loan with a balloon. Here are some basics about adding a balloon payment in your car loan.
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If you can't afford to pay for a car upfront, you'll need to take out a car loan. However, car repayments can be expensive. If you want to cut your regular repayments, one option is to get a loan with a "balloon payment."

So, what is a balloon payment? Here we will explain the basic things you need to know about adding a balloon payment to your car loan:

What is a balloon payment?

A balloon payment is a one-off lump sum that you agree to pay your lender at the end of your car loan’s term. In exchange for owing a lump sum at the end of your loan, you are only required to pay interest on part of the principle. Because balloon payments will typically account for a large proportion of your car loan’s balance, they can reduce your loan repayments.

It is called a "balloon" because it is very inflated compared to your other payments. The payment can be up to 50% of the car’s purchase price, depending on the length of loan term and other factors. 

How does a balloon payment work?

Let’s say that you bought a vehicle that’s worth $40,000 with a car loan term of 5 years and an interest rate of 4.67%. You and your lender agree on a balloon payment of 25% or $10,000, i.e. a $30,000 loan.

Without a balloon payment, this would result in a loan repayment of $748.82 per month. With a 25% balloon, however, the repayment is reduced to $600.53 per month - a saving of nearly $150 per month. This extra money could in the interim be used to go towards the family budget, such as groceries, your mortgage or other bills, or your investments.

It is important to note, however, that you are unlikely to save money in the longer term as you still have to make the big balloon payment at the end with accumulated interest.

To summarise:             

  With balloon payment Without balloon payment
Loan amount $40,000 $40,000
Loan term 5 years 5 years
Interest Rate 4.67% 4.67%
Balloon payment $10,000 (25%) n/a
Monthly payment $600.53 $748.82
Money saved in monthly payment $148.29 n/a

While you can save money every month with a balloon payment, you still need to pay the $10,000 in full at the end of the term. So, it’s important to keep this in mind, as you don’t want to be unable to pay the lump sum at the end of your car loan.

You can use our car loan calculator to get an estimate of how much your repayments will be if you added a balloon payment to your car loan.

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The pros and cons of a balloon payment

Benefits of a balloon payment

The primary advantage of including a balloon payment in your car loan is that it makes the weekly, fortnightly, or monthly loan repayments lower. This gives you the benefit of:

  • Making it easier to fit your loan within your monthly budget and household expenses.

  • Freeing up your cash so you can put it towards your investments - the extra money put towards investments is called ‘opportunity cost’.

  • Giving you time to save up for the payment at the end of your loan term.

  • Allowing you to pay off the balloon by selling or trading in the vehicle and using the money for the repayment, then taking out a fresh loan for another car, which could be better, safer or more technologically-advanced.

Drawbacks of a balloon payment

There are also disadvantages if you decide to add a balloon payment, and it’s mainly down to the lump sum you’ll have to pay at the end. Here are some things to consider if you’re looking at a car loan with a balloon payment:

  • The cost of the loan in the long-term is higher.

  • You will end up with a big bill to pay at the end of your car loan term, which could catch you unawares if you forget about it. This could be anywhere from a few thousand to many tens of thousands of dollars.

  • Longer loan terms (e.g. five years versus three years) generally have lower maximum balloon payments.

  • Although this is true of any car loan, you’ll have to consider depreciation, and how paying a lump sum stacks up against how much your car has depreciated if you decide to sell it, or if you can’t afford the final loan repayment. Owing more on the car than its worth is called ‘negative equity’.

What happens to balloon payments at the end of the loan term?

When your car loan ends, say after 3 or 5 years, this is when the balloon payment likely kicks in. If you can’t pay the full amount in cash, you might need to be able to sell the vehicle to do so.

Depending on how much your car has depreciated, and how much you owe as part of the final payment, you could end up owing more than you sell it for. This is why longer loan terms often have lower maximum balloon percentages.

According to the Australian Bureau of Statistics, the age of the average car on the road is 10.1 years. So, chances are, once your loan term is up, you might like to hang on to your car for a few more years. However, paying off the balloon amount could present an opportunity to hop into a newer, safer and more technologically-advanced vehicle.

What are your options when your balloon payment is due?

There are several options available to you when your balloon payment is due:

Make the final car loan repayment

Arguably the most obvious option is paying off the the final loan balance owed using your own cash, giving you complete ownership of the vehicle. This isn’t usually a very popular option, as balloon payments are typically a significant amount of money which most people don’t have lying around.

Sell the car

Selling the vehicle is usually the most popular option for when your balloon payment is due. Selling the car will typically cover the cost of the balloon payment, at which point you can then buy a new car and apply for another loan.

Trade in the car

Trading in the vehicle works much like selling it. However, you can pick out the new car you would like and your balloon payment will form part of the payment for this new vehicle.

Refinance

Some lenders will allow you to refinance the balloon payment so you can pay it in instalments, rather than a lump sum. Of course, this essentially negates much of the benefits of the balloon feature, and you will likely have to pay interest on this refinanced amount.

Who benefits most from a balloon payment?

Balloon payments are often used by small businesses and sole traders who’d rather free up cashflow to invest back into their business. By the same token, balloon car loans can also suit people who like to upgrade their vehicle every few years. Motorists can usually repay their balloon payment by trading in their vehicle, and then purchasing a new one (either via finance again or cash).

The balloon bottom line

Adding a balloon payment to your car loan is just one of the many considerations you’ll have to make the next time you are ready to finance a new car. Other factors include the car loan deposit size, loan terms, and more.

Balloon payments will give you the benefit of lower ongoing repayments but it is crucial to make sure that you will be able to settle the balloon payment at the end of the loan term.

If you’re ready to hop into your new set of wheels, speak with one of our lending specialists today to find out how to get pre-approved for your next car loan.

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