When it makes sense to buy a car with a balloon payment

Finance experts often warn that balloon payments are a risky way to pay off a new car, but there are situations where it can be a helpful option for consumers.

A balloon payment refers to a type of finance plan where a portion of the car’s value is set aside to be paid at the end of the contract term.

In doing so, a person is able to significantly reduce the amount they need to pay on their monthly instalments, which can make it seem like a great option for those on a tight budget.

However, that large sum still needs to be paid at the end of the contract, and many individuals who opt for a balloon payment often find themselves in a situation where they are unable to pay the outstanding amount when their contract comes to an end.

It’s for this reason that industry experts caution motorists against using a finance plan with a balloon payment, but it can still be useful if you know what you are doing.

Ernest North, co-founder of Naked Insurance, recently outlined a few scenarios where a balloon payment can make sense.

“Despite the costs and risks, there are some instances where balloon payments can be a helpful tool in your financial planning,” he said.

This includes the following situations:

• You can realistically expect your income and savings to increase over the loan term.
• You like to trade your car in for a new model every few years and are confident you can afford the balloon payment when it’s due.
• You want a reliable new car with a warranty, rather than risking potentially higher and unpredictable maintenance costs with an older one.
• You are paying for the car through a business and can claim tax deductions on depreciation, interest, fuel, maintenance, and potentially the balloon payment to help with cash flow.
• You don’t anticipate needing to exit the loan early and are committed to keeping the car for the full loan term.

In all of these cases, it is important to understand what you are signing up for in the long run, as a balloon payment of 20% on a R500,000 car will leave you with a R100,000 lump sum that still needs to be paid at the end of the contract.

Guaranteed Future Value vs balloon payment

One other option to consider is a Guaranteed Future Value (GFV) finance plan, which are generally seen as a safer alternative.

“GFV agreements add a layer of financial security by guaranteeing the value of your car at the end of the finance term, regardless of how much it has depreciated,” explained North.

“This guaranteed amount functions as your balloon payment (also known as the “optional final payment”) and is agreed upon upfront.”

When the finance term ends, you are left with three choices.

You can make the final payment and keep the car, trade it in for a new car, or give the car back without needing to pay the final amount, even if its actual market value is lower than the GFV.

The advantage of a GFV plan is that it avoids a situation where a motorist still has to pay for a car that is now worth less than the lump sum they are on the hook for.

Most importantly, North warned against the practice of using balloon payments to purchase a car that the person can’t really afford.

“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.”