September 26, 2018

What is a Car Loan Balloon Payment and How Does it Work?

Learn exactly what a car loan balloon payment is, why you might consider it and how it could affect the cost of your car loan.  

What is a balloon payment on a car loan?

A balloon payment or “residual value” is an agreed-upon lump sum that you will pay to your lender at the end of the car loan term. Effectively, the balloon amount builds over the period of the loan by diverting a portion of your interest payments into it, so that your monthly payments (from a cash perspective) are reduced. Balloons are usually a significant lump of your loan amount (eg. 30-50%), which is why they have the ability to reduce the amount of your monthly repayments in such a substantial way.

For example, if Daniel took out a $30,000 car loan for 5 years at 6% interest and had a (30%) balloon of $9,000, his monthly payments would be reduced from $579.98 (no balloon) down to $451.  At the end of his loan term, he would then have to pay the $9,000 sum left over in full.

It’s important to remember that while car loan balloon payments are helpful because they reduce your monthly repayments, they do in effect charge you more in interest across the term of the loan. Looking at Daniel’s case a little closer, we see that with a 30% balloon, Daniel’s interest costs are $1,260 more.

Cost of a $30,000 5 Year Car Loan at 6% Interest Rate (Excl. fees)
30% Balloon No Balloon
Monthly Repayments $450.99 $579.98
Total Repayment after 5 years (Repayments + Balloon) $36,059.40 $34,798.80
Interest Costs $6,059.40 $4,798.80
Cost Difference +$1,260.20

Source: Loans.com.au Car Loan Calculator.

Why you might consider a car loan balloon payment

There are a number of reasons why someone might consider having a balloon payment on their car loan. The first is that the repayments are less per month when compared to a car loan with no balloon. This provides a lot more cash flexibility, particularly for people who may have other expenses to pay (or less income coming in) for the period of the loan. It can also have the added benefits of qualifying for a larger car loan amount.

A lot of people also consider car loan balloons because there is an option for them to trade in their car at the end of the term and use the proceeds to pay off the balloon. They can then apply for a new car loan to fund the purchasing of a replacement vehicle. This is quite common for business car loans.

What is the process when the balloon payment is due?

The balloon payment must be made as a lump sum once the car loan has expired. There are typically a number of options available once the payment is due.

  • If the borrower wants a new vehicle, they can sell the car and use the money to make the payment and finalise the loan. The borrower is then entitled to buy a replacement car and if they wish, apply for a new car loan to pay for the replacement vehicle. If the car is being traded in as a part of the payment for the new vehicle then the Balloon Payment can be included in this process.
  • If the borrower wants to keep the vehicle, they can make the payment in cash, roll over or refinance the payment into another loan.

Balloon payments in business car loans

Because of the flexibility of smaller monthly repayments and the opportunity to replace your car every three to five years, balloons are commonly found in car loans for business and commercial purposes. Reducing the monthly repayments on a car loan can help a business to manage its short-term cash flow more effectively, while the higher interest rate charges can be claimed as a tax deduction.

If you’re interested in taking out a car loan balloon payment for business purposes, it’s a good idea to consult a tax accountant or financial adviser to find out how it could benefit your business.

The Savings Lesson

Having a balloon on your car loan will not save you money, because you will have to pay a higher amount of interest across the life of the loan. However, it will provide you with the great flexibility of lower monthly repayments. Remember though that while it will help you save on your outgoing expenses during the term of the loan, there’s a lump sum that needs to be paid at the end of the loan. Make sure to shop around for a low interest rate before making a purchase decision and calculate your possible monthly repayments in advance using a car loan repayment calculator. 

About the author  ⁄ Marxa Dillan

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