If you're looking at getting a car loan, you may come across some that offer a balloon or residual payment option. These loans can help reduce your repayments but require you to make a large lump sum payment at the end of the loan term.
While a balloon payment can help save you money, it's important to understand how they work and how they differ to residual payments before you take on a loan that offers them as a feature.
What is a balloon payment?
A balloon payment is a single, lump sum payment that is made at the end of a loan term to cover the remaining cost of the loan. It is commonly found as part of dealer finance, but is also offered on some car loans. The balloon payment amount is only payable at the end of the loan, meaning it can help reduce the size of your regular repayments.
Balloon payments are suited to people who want to purchase a new vehicle or upgrade their existing vehicle affordably. Balloon payments allow people to maintain a healthier cash flow by keeping their repayments lower.
You may want to consider a balloon payment if you:
Want to keep your repayments as low as possible.
Want to save interest over the life of the loan.
Intend to sell your vehicle or upgrade your car again at the end of the loan term (i.e. refinance your car loan).
Are expecting a payout or higher income at the end of the loan term.
What happens if you can't afford a balloon payment?
If you can't afford a balloon payment, you have 2 options:
Refinance. You can take out another loan to cover the cost of your balloon payment. This loan will then extend your repayment period by another 1 to 7 years. To be able to do this though, you will have to re-apply and re-qualify for finance.
Sell your asset. You can also opt to sell your asset and use the funds from the sale to meet the repayment. If your asset is no longer worth the value of the balloon payment, you will have to cover the difference another way.
What's the difference between a balloon and residual payment?
Both a residual and balloon payment refer to the amount left over at the end of a loan term and which needs to be paid out at that time. The key difference lies in how these amounts are determined.
A balloon payment is set in an agreement by the borrower and the lender in order to lower the ongoing monthly repayments and does not take depreciation into account.
A residual payment is forecast based on how much the asset will be worth once the loan term finishes, taking into account depreciation.
Pros and cons of balloon payments
Pros
Repayment reduction. This is the main advantage of balloon payments. The amount is subtracted from the principal loan amount and your repayments are lowered as a result. This can allow you to finance your car purchase while still keeping your repayments affordable.
Flexibility of the balloon payment amount. The amount of the payment is generally flexible, so you can agree on the amount with the lender. A standard payment is a few thousand dollars, but can be more or less depending on the lender.
Business benefits. The increased amount of interest payable may have benefits to those borrowing for business purposes. You will be paying less principal and more interest, and as the principal is non-deductible this can work out in your favour in terms of tax.
Cons
Higher long-term costs. The cost of a loan can be higher in the long term, especially in cases where the loan is interest-only.
Greater risk. Balloon payments pose an increased level of risk to traditional loans, due to the repayment schedule. There is also the risk that you will be unable to come up with the cost of the balloon payment when it is due.
No guarantee of refinance. If you are unable to pay the balloon payment with your own money and decide to take out another loan to cover the cost, there's no guarantee that you will be approved.
Reduction of equity in the car. Your car may depreciate in value faster than your repayment schedule. This could mean that the car is no longer worth the value of the balloon payment when it comes up.
What to consider when comparing financing options with balloon payments
Before opting for a balloon payment at the end of your term, ask yourself the following:
How much additional interest will you be paying? While your repayments are lower, working out how much the lowered repayments are costing you in additional interest over the loan term is an important step. Are the long-term costs worth the short-term savings?
How will you pay off the balloon payment? Do you have a savings plan to be able to pay off your balloon payment at the end of the loan term? Will you be refinancing or putting it on a credit card? Do you have an end-goal in mind for how you will manage the payment?
Dos and don'ts of balloon payments
Dos
Opt for a car you can afford. Just because your upcoming repayments will be made lower by a balloon payment doesn't mean that you should opt for a car that is out of your price range. Be realistic about your choices, and don't borrow more than you can afford to repay.
Put money aside for your balloon payment. If possible, it's a good idea to put some money aside each month to put towards your balloon payment. If you put the money into a savings account, you can even earn interest on it. This could mitigate some of the loan costs.
Weigh up your refinancing options. When the balloon payment is due, you can consider taking out a new loan to pay off the balance with. Make sure that you weigh up all the pros and cons of refinancing before committing to more debt.
Don'ts
Take on more than you can afford. Consider how hard the balloon payment is going to hit your finances when the time comes. Try to be as realistic as possible with your financial decision making.
Opt for a car that quickly depreciates. While ultimately the type of car you want to buy is up to you, it's a good idea to try to opt for a car that holds its value as well as possible. This way, if you have to sell your asset to cover the remainder of the balloon payment, you're less likely to make a loss.
Example
John wants to borrow $18,000 for a car, with a loan term of 5 years. While this would normally mean he makes monthly payments of $300, plus interest, he chooses to include a balloon payment of $5,000. This means he only makes repayments on the remaining $13,000 (as well as interest on the entire loan amount), which works out to be $216.67 each month, plus interest.
Are there any limits on a balloon payment amount?
Balloon payments are usually capped at a maximum 50% of the total loan amount. If you had a 50% balloon on a $50,000 vehicle loan, you'd have to pay a balloon payment at the end of the loan of $25,000. However, some lenders may require less than this. Different lenders will also apply different caps to their loan products.
Should you refinance a balloon payment?
Many dealerships make their money by refinancing balloon payments. If you're coming to the end of your loan term and unable to pay your balloon payment outright, refinancing is an option to consider.
You should consider this as a new credit product and give it the same consideration you would any other loan. Remember that you don’t need to refinance with the same lender, so you should compare your refinancing options before you apply.
Does a balloon payment affect a car's resale value?
A balloon payment is a fixed percentage of the loan, not of the car's actual worth. Therefore, the balloon payment will not impact the value of the car in any way.
However, if you do sell the car before the balloon payment is due, you will still have to make the balloon repayment, and therefore won't be able to retain the funds from the sale of the car.
Can you pay off a balloon payment early?
Whether you are able to repay a balloon payment early or not will depend on your lender and the loan product in question. Some lenders will allow for penalty-free additional repayments and/or early repayment. However, some lenders may charge a fee for paying off a balloon payment early. To check the policies of any of the lenders featured on this page, simply click on the loan product of your choice to visit the lender's review page.
If you're considering repaying your balloon payment early, it may also be worth considering weighing up how much money you will save on loan interest versus how much money you could gain from investing the money in question until the balloon payment is due. On the other hand, if you can earn a higher rate than the rate on the loan, it is better to invest the money and wait until the balloon is due. If the loan has a higher interest rate, you save money by paying off the balloon early.
Car loans that offer balloon payments can be a good option to consider as they help keep your ongoing repayments low. However, as they leave you with a large payment to deal with at the end of your term, it’s important you understand everything about this financing option before you apply.
Elizabeth Barry was the lead editor for Finder. She has over 10 years' experience writing about a range of topics with a focus on personal finance. You’ll find her writing and commentary in a range of publications and media including Seven News, the ABC, MSN, the Irish Times and Singapore Business Review. See full bio
Elizabeth's expertise
Elizabeth has written 211 Finder guides across topics including:
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Is a car dealer liable to disclose a Balloon payment on the loan agreement document, during signing a Commercial loan & mortgage agreement?
Can the dealer charge Balloon payment at the end of the loan period if it has not been agreed upon or shown on the loan document?
Thank you.
Finder
ElizabethMay 23, 2016Finder
Hi Gopinath,
All fees, interest and payments, including balloon payments, need to be properly disclosed to you before you sign on to a loan. If the balloon payment wasn’t in your loan contract then you should get in contact with your car dealer to discuss this. If the issue isn’t resolved (that is, they are still requiring you pay the balloon payment) then you may want to lodge a dispute with the Credit and Investments Ombudsmen. You’re able to lodge a complaint online by visiting its website.
Hope this helps,
Elizabeth
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Is a car dealer liable to disclose a Balloon payment on the loan agreement document, during signing a Commercial loan & mortgage agreement?
Can the dealer charge Balloon payment at the end of the loan period if it has not been agreed upon or shown on the loan document?
Thank you.
Hi Gopinath,
All fees, interest and payments, including balloon payments, need to be properly disclosed to you before you sign on to a loan. If the balloon payment wasn’t in your loan contract then you should get in contact with your car dealer to discuss this. If the issue isn’t resolved (that is, they are still requiring you pay the balloon payment) then you may want to lodge a dispute with the Credit and Investments Ombudsmen. You’re able to lodge a complaint online by visiting its website.
Hope this helps,
Elizabeth