It goes by many names: balloon payment, residual, guaranteed future value.
Regardless of what it’s called, it’s something that can help or hinder you on your car-buying journey if you don’t understand it.
Many South Africans who finance cars nowadays use balloon payments to lower their monthly instalments or to get into vehicles that fall out of their budget.
The common misconception is that a balloon payment acts like a deferred deposit, making the car cheaper and lowering the “financed amount” – but many buyers fail to make good use of the money they’re saving each month.
Ghana Msibi, CEO of Wesbank’s Motor Division, explains: “This is not what a balloon payment is designed for. Rather, it is intended to assist with cash-flow management at the start of the agreement.”
Astute buyers may therefore opt to invest the extra funds that a balloon payment has freed up.
Unfortunately, many buyers do not do this – nor do they take into account money that needs to be paid at the end of the finance agreement.
Lowering the purchase price
In simple terms, a balloon payment is used to lower the monthly finance payments you have to make by setting aside a portion of the purchase price – up to 35% in some cases – when you buy a car.
If a buyer intends to pay off their car to the end of the finance term, the money saved through lower monthly installments will need to cover the balance outstanding at the end of the agreement.
Depending on the car, it’s likely that after five or six years of diligent payments, the buyer will still have to stump up a third of the original price in order to take ownership from the bank.
If a balloon payment is used to purchase a second-hand car, the value of the used may likely be less than the residual value – even after reaching the contract end.
Msibi said that with many South Africans upgrading their cars “more often than is financially viable”, buyers needs to understand the “breakeven point” of their finance agreement.
This typically comes in at around 36 months on a regular finance agreement, and is when the car’s trade-in value matches the amount still owed to the bank.
However, when a balloon payment option is selected, this outstanding amount needs to be added onto the amount you owe – and can push the breakeven point back by 12-18 months.
“It’s a dangerous trap to fall into, and we encourage buyers to only change cars after the breakeven point has been reached,” he said.
It is also important not to view a balloon payment as an alternative to an upfront deposit.
A substantial deposit on a car will always reap dividends further down the financial road, because it brings the breakeven point forward and lowers the monthly repayment costs.
On top of of this, car buyer must take other expenses into account – including fuel and insurance – when laying out a car-buying budget.