How to pop balloon payments

More South Africans are turning to balloon payments to drive off in new cars with lower monthly instalments. But the deal comes with a catch.

“Lowering your monthly repayments can help you to stretch your salary a bit further and potentially afford a better car,” says Ernest North, co-founder of Naked, a car and home insurance platform. “But the lump sum at the end of the loan term is the sting in the tail.

“While a balloon payment can be a useful financial planning tool, all too many people find that they struggle to afford the final repayment.”

South African banks report that up to one-third of car loan customers are choosing the maximum balloon payment to reduce their monthly repayments. North says balloon payments have become increasingly popular in SA due to the rising costs of living, including the higher costs of car purchases and ownership.

What is a balloon payment?

A balloon payment is a lump sum that becomes due at the end of a car finance term, typically between 20% and 35% of the vehicle’s value, with most banks capping it at around 40%. It reduces monthly instalments during the term because the borrower is only repaying part of the loan rather than the full amount.

For example, if one buys a R500,000 car over six years at 10.5% interest with no deposit, the monthly repayment is R9,481 without a balloon payment. With a 40% balloon payment, the monthly repayment falls to R7,475, but a R200,000 lump sum is due at the end of the term. Overall, the total cost of credit is about R682,000 without a balloon payment compared to R738,000 with the 40% balloon.

When the balloon payment becomes due, one can:

• Pay it off in cash and own the car outright.
• Refinance the outstanding balloon payment, which involves entering a new loan agreement and continuing with monthly repayments and interest charges. This option depends on qualifying for new financing.
• Extend the loan term, if the lender allows it, although this usually results in higher overall interest costs and is only available to creditworthy borrowers.
• Sell or trade in the car, which leaves no asset after months of payments, while still requiring settlement of the balloon amount.

Balloon payment risks

These figures and scenarios highlight the significant risks and costs of balloon payments. The short-term saving on monthly instalments is relatively small compared to the long-term exposure:

• A large cash sum or new financing is required at the end of the term to settle the balloon payment.
• Higher balloon amounts increase the total interest paid over the loan period.
• After depreciation, the vehicle’s value may be lower than the balloon payment still owed.
• Continuous refinancing every five or six years can prevent full ownership of a vehicle.
• Exiting the loan early can trigger settlement penalties along with the outstanding balloon balance.
• In the event of theft or a write-off, early settlement may result in a substantial shortfall.
• Inability to pay the final balloon amount can lead to repossession of the vehicle under the National Credit Act.

North says: “In theory, a balloon payment gives you the option to pay a large cash amount at the end of your finance term and then you can keep the car. But the reality is that most people don’t have that kind of cash lying around, so they end up having to sell the car.

“And if the car’s value is less than the outstanding balloon amount, it becomes a very serious problem – one that many people are unfortunately facing.”

When balloon payments can work

Despite the costs and risks, there are situations where balloon payments can be a useful financial tool:

• For motorists who trade in their cars regularly and are confident they can settle the balloon payment when it falls due.
• When income or savings are expected to rise over the loan term, making the final payment more manageable.
• For buyers prioritising a new, reliable vehicle with a warranty, rather than facing uncertain maintenance costs on an older model.
• In cases where the purchase is made through a business, allowing tax deductions on depreciation, interest, fuel, maintenance, and potentially the balloon payment itself.
• Where there is no intention to exit the loan early, with a commitment to keeping the car for the full term.

Guaranteed future value vs. traditional balloon payments

A guaranteed future value (GFV) finance option is sometimes presented as an alternative to traditional balloon payments. Under a GFV agreement, the future value of the car is fixed at the start of the finance term, regardless of depreciation. This amount serves as the balloon, also called an optional final payment.

At the end of the term, the customer can either make the final payment and keep the car, trade it in for a new model, or return it with no further payment required, even if the market value is lower than the agreed GFV. This structure reduces the risk of owing more than the vehicle is worth at the end of the finance period.

With regard to using balloon payments to buy a car that may not be affordable in the long term, North says: “Rather, put down a larger deposit or choose a more affordable car. Remember, a more expensive car will also have higher maintenance and insurance costs. While it can make sense in some circumstances, the downside of a balloon payment is very seldom worth the benefit.”