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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.
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 amount 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.
What are the benefits of a balloon payment?
Balloon payments offer a number of advantages, including:
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.
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?
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.
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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 as you would give before taking on 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.
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 is Finder's global fintech editor. She has written about finance for over six years and has been featured in a range of publications and media including Seven News, the ABC, Mamamia, Dynamic Business and Financy. Elizabeth has a Bachelor of Communications and a Master of Creative Writing from the University of Technology Sydney. In 2017, she received the Highly Commended award for Best New Journalist at the IT Journalism Awards. Elizabeth's passion is writing about innovations in financial services (which has surprised her more than anyone else).
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