The real risk of balloon payments

You can reduce monthly instalments on a new car if you agree to pay a balloon payment at the end of your loan term. But this may not always be the best option for you, finds Angelique Ruzicka.

You could buy a new Golf BMT Trendline for R2,999 per month, provided you put down a 14.55% deposit and agree to pay a balloon payment of R99,507. If you are after a bigger car, VW are currently advertising the Touareg for R6,599 a month. The catch? A whopping balloon payment of R316,700 on top of a 20% deposit. Your total payment for the Touareg will come to R554,269*.

VW are of course not the only company offering packages with balloon payments and dealerships commonly offer this payment structure to make car finance deals more appealing. But should you really venture down this path to get a new or used car?

Cheap but not always cheerful

A residual allows you to defer a portion of the amount owing on the vehicle until the end of the loan period – typically three or five years – and then pay it off in one lump sum. So if a car was valued at R200 000, you might choose a balloon option of 25%, which means that when the loan agreement ends you would be liable for a lump sum of R 50, 000.

The advantage to buying a car with a residual (or balloon payment) is that the monthly instalments are more affordable. “In the short term, your monthly repayments will be low. However at the end of the repayment term, you will be left with a lump sum still owing,” says Glenn Stead, head of the personal segment at Standard Bank Vehicle Asset Finance. “This isn’t necessarily a reason not to take the offer, but you need to have a clear understanding of the process.”

Ownership vs. non-ownership

You can choose between two different types of balloon payments – known as ownership and non-ownership residuals. In an ownership situation, you are buying the car and are responsible for the lump sum at the end of the loan term. With non-ownership, the bank or lender still owns the car at the end of the loan period, and is also responsible for reselling it to cover the balloon payment. In effect, you are leasing the car from the bank. Make sure you understand which it is that you are agreeing to.

“There are benefits and drawbacks to both scenarios,” says Stead. “With non-ownership the lender is responsible for the balloon payment so you don’t have to worry about finding the money. But there might be certain restrictions you have to comply with, like a mileage ceiling on the vehicle to ensure the resale value.”

With an ownership option you would be responsible for the payment at the end of the loan, although ownership of the vehicle will be transferred to you. But this could land you into trouble if you haven’t saved up in the interim to cope with the large lump sum payment.

However, there are options still available to you if you can’t afford to pay off the residual. “It is possible to refinance the car, and pay the balloon payment off over a longer period, or you can sell the car,” says Stead. “In some instances, the value of the car can be less than the residual owing, meaning that even if you sell the car, you’ll still owe money to your lender.”

In both scenarios, you will be required to have insurance so that if anything were to happen to the vehicle, you or the lender would be covered.

Be a savvy buyer

“People have different priorities when purchasing vehicles,” says Stead. “Some want to pay them off as quickly as possible, and then own the car. Others want to keep driving the newest model of their vehicle. For those folks, finance with a residual payment is an option, but it’s worth remembering that if you keep buying a car on residual, you are allocating a portion of your income to your car indefinitely.”

Stead explained that lately more vehicle finance borrowers have been defaulting regardless of the payment structure they opt for. “I believe inflation is higher than the 4% they say it is However, a residual payment is not a good idea if you’re trying to save money. “Residual payments can cost you more in the long term, and if you’re short of cash, you’re probably not going to have the funds at the end of the loan term. Rather try to buy a cheaper vehicle with monthly payments that you can afford,” advises Stead.

For more about how to get the right vehicle finance deal for you, click here.

*All prices correct at the time of publication, 1 August 2013 and are subject to change thereafter