Many South Africans are turning to balloon payments to keep up with the price of new cars, but this solution is likely to cost them far more over the long term.
This is according to Ernest North, co-founder of Naked Insurance, who recently warned motorists about the risks involving with buying a car on a finance plan with a balloon payment.
He explained that balloon payments have balloon payments have become increasingly popular over the last few years as households continue to grapple with the rising cost of living and are looking for ways to minimize their monthly spending.
This explanation correlates with data provided by Lightstone Auto, which revealed that the average car loan period now spans 72 months (six years).
A longer loan period means a person will spend less on their monthly instalments, but they will end up paying significantly in interest by the time their contract comes to an end.
Balloon payments take a different approach, as they allow you to repay a portion of the car’s value at the end of the contract, rather than up front.
Most finance plans with this arrangement use 20% to 35% of the vehicle’s value as the “balloon,” and most banks will not approve an amount beyond 40%.
The draw of a balloon payment is that it reduces the individual’s monthly instalments, because the amount is calculated on the remaining portion of the car’s value and not the full amount.
This makes it a tempting option for cash-strapped households, who may sign up for one without fully understanding the risks involved.
“Balloon payments have become increasingly popular in South Africa due to the rising costs of living, including the higher costs of car purchases and ownership,” said North.
“However, many consumers go for a balloon payment without understanding that they could get caught in a debt trap four or five years down the line.”
The risk with this type of finance plan is that the remaining value of the car still needs to be paid off at the end of the agreement, and many consumers do not effectively budget for.
This means they are unable to repay the final loan amount and will fall into a debt trap where they now have to repay this lump sum, even though they have been paying every month for the last 5+ years.
“Lowering your monthly repayments can help you to stretch your salary a bit further and potentially afford a better car,” said North.
“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.”
How a balloon payment works
Naked illustrated what a finance plan with a balloon payment looks like in practice using a table.
The calculations are based on a R500,000 vehicle with a six-year loan at an interest rate of 10.50%.
| Balloon | Monthly payment | Lump sum at end | Total cost of credit |
|---|---|---|---|
| No balloon | R9,481 | R0 | R682,000 |
| 20% balloon | R8,478 | R100,000 | R710,000 |
| 40% balloon | R7,475 | R200,000 | R738,000 |
When the balloon payment is due, you have the following options:
- Pay it off in cash and own the car outright.
- Refinance the outstanding balloon payment. You’ll enter a new loan agreement and face another few years of making monthly payments and interest charges. You will need to qualify for financing to take this option.
- Extend the loan term. Some lenders might allow you to stretch out your repayment period further, though this could mean paying even more interest costs. Again, this is only possible if you’re creditworthy.
- Sell or trade in your car, leaving you without an asset after forking out cash for months. But remember, you’ll still need to settle the balloon payment.
It’s a finance option that can be useful under the right circumstances, but for many individuals, it’s a financial trap that will cost them far more over the long run.
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