A balloon payment as part of your car loan structure can give you additional flexibility to afford the vehicle you want today.
In practice, it reduces the size of your regular repayments throughout the loan period with a larger residual, or balloon payment at the end.
In this article, we will explain how a residual payment works and how to use it to your advantage when selecting the right car loan for you.
In This Post:
What is a Balloon Payment?
A balloon payment is a larger, lump-sum payment, due at the end of a car loan term. The amount is pre-determined in your loan contract and is intended to separate part of your loan into two parts:
- An amount to be repaid throughout the loan term – your regular repayments will cover the principal and interest similar to a typical loan, with the balance reaching $0 by the end of the loan term.
- A separate amount where no principal repayments are due until the final “balloon” payment is made at the end of the loan term.
How Are They Different From Regular Payments?
Regular payments distribute the loan’s principal and interest evenly over its full term, resulting in predictable, consistent amounts.
In contrast, balloon payments shift a portion of the principal to the end. This creates an uneven repayment structure that requires forward planning. We will discuss this more later in the article.
Here is a simple example so you understand the concept before we move on:
Why Use a Balloon Payment?
Most borrowers use a balloon payment to reduce their ongoing repayments during the loan term. This helps a borrower manage their cash flow.
A balloon makes sense for someone who has a better use for that money in the short term. This could include paying off more expensive debt, making investments, or covering short-term expenses.
However, if you are less interested in short-term savings and want the best possible car then the lower minimum repayment could instead increase the amount you can borrow. Allowing you to buy a higher-quality vehicle.
How Balloon Payments Work
The easiest way to understand a balloon payment loan structure is to think of the final payment as an interest-only component of your loan.
If we stick with the $30k car loan example above then your repayments would be calculated based on the following components:
- $20k – Principal and interest repayment to pay off the balance in 5 years.
- $10k – Interest-only component where only the interest is payable over the 5 years.
If we assume a 7.99% interest rate then we can start to calculate the total repayment amount:
| Component | Loan Amount | Monthly Repayment |
|---|---|---|
| Principal & Interest | $20,000 | $405.00 |
| Interest Only | $10,000 | $66.58 |
| Total | $30,000 | $471.58 (x 60 months) |
| Balloon Payment | $10,000 |
Balloon payment vs Regular Car Finance
Now that we have broken down how the balloon affects your repayments we can do a comparison with a regular loan over the same period.
As you can see from this example, the loan structure that includes a balloon payment will cost you $1,832 more over the term of your loan.
Risks of a Balloon Payment
The obvious risk is that the borrower will not have the funds to repay the balloon payment when it is due.
Failure to pay the balloon payment can lead to severe consequences, such as loan default or asset repossession.
However, you do have the following options to avoid this course of action.
Refinance the Loan
If you have paid down your loan over five years then the residual principal amount should be less than the value of the vehicle.
Lenders will not allow a balloon payment over the forecast depreciated value of the car at the time the balloon payment is due.
As long as your financial circumstances have not deteriorated you may be able to refinance the vehicle into a new loan to pay down the amount over time.
If you have a balloon payment coming up and you are not sure how you will pay it then speak to one of our expert brokers to discuss your options.
Sell the Vehicle
The resale value of the car should be higher than the balloon payment if you have looked after it well. This will allow you to sell the asset and pay off the loan without consequence.
You may have surplus funds after the sale that you could put toward your next car. This has the benefit of re-setting your finances so your commitments are manageable, and you get to upgrade your car at the same time!
If you are looking to sell your car then speak to the team at Gusto Auto to get a quote on your trade-in value and financing options for your next vehicle.
Advantages and Disadvantages
Benefits of a Balloon Payment
The balloon payment will improve your cash flow position throughout the loan term.
This will be of most benefit if you have:
- An important need for funds in the short term and you would like to relieve pressure on the household budget.
- You have higher-cost debt that you want to pay off as quickly as possible.
- Access to investment opportunities that are likely to generate more money than the additional cost of the balloon payment.
- A need or desire to purchase a more expensive vehicle than what a regular car loan would facilitate.
- A desire to have flexible options at the end of your loan term. E.g. upgrade your car.
Disadvantages of a Balloon Payment
While balloon payments can be advantageous, there are notable drawbacks to consider. The primary concern lies in the substantial lump sum payment due at the end of the loan.
Here is a summary of the cons that you should consider:
- The overall cost will be higher.
- The lender may cap your balloon payment at a lower amount than desired. Especially if your loan term is longer and the car will depreciate more over time.
- You need to have a plan for repaying the balloon payment well in advance or it could affect your credit score.
- The final date may sneak up on you and could cause financial stress.
- If your car is damaged the value of the asset may not cover the balloon payment if you need to sell. Resulting in a shortfall in the loan amount.
- If used vehicle prices fall sharply in the coming years then you may also be left with an unexpected shortfall.
If you can manage these potential downsides then you can make a balloon structure work to your benefit.
Conclusion
You should consider a balloon payment only if you have a better use for the money that you save, and you remain disciplined in directing that money over the course of the loan term.
If not, regular auto finance is likely to be more suitable so there are no unwelcome financial complications to deal with in the future.
Our brokers can help you decide if a balloon payment is right for your long-term objectives. Submit an inquiry below to get in touch.
