One of the car financing solutions that you may come across when selecting the type of financing is a balloon payment. While selecting a vehicle loan, an added advantage can be obtained if you can afford a balloon payment on your vehicle loan. However, one needs to be aware of this concept and whether it fits their financial capacity or not.
What is a Balloon Payment?
A balloon payment is the final lump sum payment made towards the repayment of a loan. Balloon payment refers to the final, and usually large payment made at the end of the period of loan. It is often given the name ‘balloon’ payment because is much larger than the rest of the monthly payments that you’ve been making. For example, if you decide to use a car financing option that has a five-year term with a balloon payment, you may have to pay lower monthly amounts for 59 months and then pay off the remaining balance in the 60th month.
Balloon payments are normally applied in vehicle financing to make monthly installments slightly doable. But this is done at the expense of the large lump sum that is payable at the end of the agreed period which can be very costly if one is not financially ready to meet the costs.
How does Balloon Payments Work?
If you are to engage in vehicle financing that comes with a balloon payment, then the lender structures the actual loan amount in such a way that the outstanding balance of the loan will have to be repaid at a later date. This leads to the monthly payments being less, making it seem like you are paying for the vehicle loan only without considering the total amount you’ll have to pay at the end of the period. However, the disadvantage of such an approach is the fact that the deferred portion of the principal amount must be paid in full upon the end of the term indicated for a certain loan.
For instance, you purchase a car with a price tag of $30000 and borrow the amount by taking a 5-year vehicle loan. In a normal loan repayment structure, your monthly repayments would be made in such a way that they would cover the total amount of the loan of $30,000 in five years. However with balloon payment, you may be paying say $2500 every month for five years, and then the rest of $1250 at the end of the five years.
The Pros of Balloon Payments
- Lower Monthly Payments: The main benefit of the balloon payment is that the monthly payments are considerably less compared to other financial products. This can make your vehicle finance more manageable if your budget is slightly limited, or if you think that your income is likely to rise shortly.
- Flexibility: This is especially important when planning to sell the vehicle or when making an early repayment of the loan balance before the balloon payment date. For instance, if the value of the vehicle is higher than the amount that is balloon paid, you can sell it and use the money to repay the vehicle loan.
- Short-term Affordability: If ever you are in a situation where you require a vehicle but do not necessarily want the monthly installments to be very high, then the balloon payment loan can be considered as a part of your vehicle financing plan.
The Cons of Balloon Payments
- Financial Risk: The main disadvantage is the financial exposure that accompanies it. Remember, even though you can afford the small monthly payments, the balloon payment at the end of the loan’s term can put you in a tough spot if you are not financially ready for it. If the final payment is not made, it means that the car can be repossessed by the owners or the bank.
- Interest Costs: Balloon payments are also costly in the long run in terms of charges for the overall interest on the loan. As you are going to be paying some of the principal in the future then expect to be paying more interest than having a car loan.
- Depreciation Risk: Cars mainly experience a decline in their market value over time and this is normally referred to as depreciation. At the end of the auto loan, your car’s value might decrease, and this means if you are facing a big balloon payment, you might end up owing more than the actual value of the car, and this makes it hard to sell or to refinance.
Things to Remember
The key advantage is that balloon payments help bring down the monthly installments involved in the vehicle finance plan, but they have their dangers. Of course, one has to consider the pros and cons as well as have some strategies on how to deal with the final part of the payment before engaging in such a kind of car financing.
