Buying a car is usually one of the bigger financial ventures you'll take on in your lifetime. Whether you're in the market for a newly arrived model or intend to approach a used-car dealer, a key step in the car-buying process is figuring out how you're going to pay for it. With the year-on-year increase in car prices, many prospective buyers find that Vehicle Financing is the only way they'll be able to afford their dream car.

When borrowing to fund a new set of wheels, buyers can choose to attach a balloon payment or residual to the loan, and what the amount will be. Including a balloon payment in the repayment plan has an impact on how much the monthly instalment will be, and ultimately, how much the car buyer ends up paying for the vehicle.

Balloon payment plans are becoming more common among car buyers in South Africa. Wesbank reports that one in every five funding agreements now includes a balloon payment that comprises around 17% of the finance amount. If you are considering making use of a balloon payment or residual, here are some things you should know before signing the loan agreement.

What is a balloon payment?

A balloon payment on a car loan enables the borrower to settle an inflated lump sum at the end of the repayment period, with interest having been accrued up until then. Rather than extending the repayment on the total cost of the vehicle over the average six-year period, the borrower and the loan provider agree that a certain percentage be pushed to the end of the finance term.

This will keep the monthly instalment amount lower but when it's time to settle the balloon payment, it needs to be paid as a single payment. If the buyer is unable to clear their debt on the balloon payment, they may need to refinance the amount due or sell the car.

A balloon payment is best explained by this example from Wesbank (via Engineering News):  “A balloon payment of 20% on a vehicle of R240 000 will result in monthly repayments of R4 739.58 (over 60 months, at 11.5% interest). At the end of the finance term, the repayments will total R284 374.84. However, the buyer will still owe a 20% balloon payment – or R48 000 – thus bringing the total price of the vehicle to R332 374.84.”

What is a residual value?

A residual is very much like a balloon payment but it takes the form of a lease agreement. It is also known as a non-ownership residual. The lump sum payable at the end of the financing period is calculated according to how much the vehicle will be worth at that time. So, if the value of the car is R50 000 at the end of the lease period, that amount becomes payable. The borrower of a residual value loan can usually get a lower premium if they buy a new car as opposed to a second-hand car, whose value will have depreciated more. The loan provider normally keeps a tight rein on the number of kilometres (mileage) travelled in a new vehicle and may levy a penalty for high mileage users. When the lease period on the vehicle expires, the borrower can return the vehicle to the financial provider for selling or sign a new lease agreement.

Is a balloon payment right for you?

Your financial provider will demand evidence that you will be able to afford a future balloon payment.  That's why financial commitment and planning for that due date is key to manage a balloon payment plan. If you're someone who always puts aside money for a future time of need and won’t mind dipping into your savings when the due date arrives, then a balloon payment may be a viable solution.

Vehicle and asset finance provider WesBank, however, advises that consumers steer clear of balloon payments since it may seem an attractive option at first, but will only boil down to increased debt in the long run.

"Buyers end up spending a lot more on the interest over the longer period of the loan, and a balloon payment, also subject to interest, could attract even more charges should a buyer decide to refinance.”

Wesbank encourages car buyers to settle for a cheaper vehicle at the shortest repayment period possible and to pay a deposit on the vehicle.

The pros and cons of balloon payments and residual valuation

Balloon payments and residuals can be confusing and overwhelming to first-time borrowers, therefore, it's important to know everything about this loan repayment structure. Below are some of the advantages and disadvantages to help you decide whether they will work for you.

Pros

• A down payment is usually not required.
• A balloon payment can help with your cash flow management.
• You will be charged a lower monthly repayment fee during the first few years.
• An increased loan size means that you will be able to afford a new or more expensive car.

Cons

• When the repayment term expires, your vehicle will be worth less than what you paid for it.
• Could lead to a continued cycle of debt as you may have to refinance the balloon payment.
• If defaulting on your balloon payment, you may be forced to sell the car, but you might not get enough to cover the outstanding amount on the loan.

When applying for Vehicle Finance, you will be required to have Car Insurance so that you and the lender are covered in the event of theft or third-party claims as a result of damage or injury. It is also important to compare Car Insurance quotes to ensure you are getting all of the savings needed to stick to your monthly budget for all vehicle-related costs. 

DISCLAIMER: The content of this article is for informational purposes only and should not be considered as financial advice. Readers are encouraged to consult a financial adviser with any questions or concerns they have regarding their personal finances.