How car loan balloon payments work

Are lower monthly payments worth the risks?

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Balloon payments can lower the monthly cost of your vehicle and the amount of money you have to borrow, but they may be risky if you don’t save enough to meet the final payment.

Ideally, you should make sure that if at the end of the contract you can’t afford the balloon payment anymore, you can walk away without consequences.

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What is a balloon payment?

A balloon payment is one large payment that’s due at the end of your loan following smaller monthly payments. In general, you may have the option of making a balloon payment in two cases:

  • You’re purchasing your vehicle through a personal contract purchase (PCP). With a PCP, you borrow the difference between the current value of the car and the value it’ll have at the end of the agreement (which is usually 1-4 years later), minus the deposit. The “final” value of the car is generally referred to as the guaranteed minimum future value (GMFV). You pay off the loan in monthly instalments and at the end you can choose between purchasing the car through a balloon payment (whose value has been established at the beginning), giving it back and walking away or entering another PCP for a new car.
  • You’re purchasing your vehicle through a lease purchase (LP). LPs are similar to PCPs, but the final balloon payment is mandatory and you have to purchase the vehicle at the end of the contract. LPs are generally used to purchase vehicles you plan to use a lot, such as business vans, because with PCPs there are normally penalties for damages and excess mileage. The drawback is obviously that you can’t opt out if the value of your vehicle suddenly decreases, or if you can’t afford the balloon payment.

What are the benefits of a balloon payment?

Although you may owe a large amount once your loan is up, balloon payments have their benefits which include:

  • Reduce your monthly payments. This is the main advantage of a balloon payment schedule. You’re only paying off your interest so your monthly payments will stay small and more affordable.
  • Build up your savings. You’ll know from the start how much your balloon payment will be. This means you can start saving for it as soon as your loan begins, earning interest on money that would otherwise be going into your lender’s pockets.
  • Balloon payments are usually a bit lower than the car value. So they can make good value for money. Conversely though, the value of a car can also fall unexpectedly, and the amount of the payment can’t usually be renegotiated. If you’re in an LP and can’t opt out, you’ll end up paying more than the car is worth.

Are there drawbacks to a balloon payment?

While there are some benefits to having a balloon payment at the end of your car loan, consider some negative features before committing to a loan.

  • It can lead to more debt. If you find yourself unable to save up for the final balloon payment, and are in an LP, you could be stuck refinancing your loan and taking on even more debt and paying more in interest.
  • You won’t own the car until you make the balloon payment. If you take out a personal loan to purchase the car instead, it’ll be yours from the beginning.
  • You can face damage and over-mileage charges if you go for a PCP.

Should I get a balloon payment? Ask these 4 questions

Ask yourself these questions if you’re on the fence about signing up for a car loan with a balloon payment at the end:

1. How much will it cost overall?

Try to work out the overall cost (and how much you’ll pay in interest) and compare it to the other two main types of car loans – that is, hire purchase and buying a car with a personal loan.

Keep in mind that a higher APR doesn’t necessarily mean a higher overall cost. For example, PCPs tend to have higher rates than personal loans, but by purchasing a car through a PCP you’ll borrow less money (only the difference between the initial value of the car and the GMFV). You’ll have to do the maths to figure out which is actually cheaper.

2. How will I pay off the balloon payment?

Many people put money away in a savings account or end up putting the amount on a no-interest current account. Whatever you decide, have a goal in mind for how you will manage the final payment. Sure, if you can’t afford it anymore and are in a PCP you can always walk away, but presumably you’ll still need a car, so…

3. What might my car be worth when it’s due?

If you enter a PCP, you can make a decision accordingly at the end of the agreement; if the car is worth way less than expected, you can just give it back and walk away.

4. Can I afford the deposit?

All car finance options that entail a balloon payment also require an initial deposit (although it can be as low as 10% of the value of the car). If you don’t have a lump sum to begin with, you should consider buying your car through a personal loan instead.

The bottom line

Purchasing a vehicle with a car finance option that entails a balloon payment can be a good shout if you want to keep your monthly payments as low as possible. However, you still need to be prepared and have a clue of what you want to do at the end of the agreement.

If you want to keep the vehicle or if you’re bound to doing so by an LP, you need to start saving early to make sure you can afford the balloon payment at the end. If you don’t, you may have to apply for a loan at the end of the agreement to meet the balloon payment, which means you’ll have to pay more interest. At that point, it probably would have been better to just purchase the car with a personal loan from the start.

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