Balloon Payments: What Are They and How Do They Work?

If you’re looking for a car loan to purchase a new set of wheels, you might come across the term ‘balloon payment’. A car loan with a balloon payment can be a handy way to help lower your repayments, but it’s important to remember there’s still a hefty amount to pay at the end of the term. This is why it’s important to understand balloon payments and how they work before choosing it as a financing option.

In this article, we cover what you need to know about balloon payments on car loans including how they work, the pros and cons, and important things to consider.

What is a balloon payment?

In a nutshell, a balloon payment is a lump sum amount that is paid to a lender at the end of a car loan’s term. Because this payment is usually a significant chunk of your loan amount, it can reduce your monthly repayments during your loan term compared to a loan without a balloon. Depending on the age and type of vehicle, the balloon amount can be anywhere from 30% to 50% of your loan amount.

While it can lower your monthly repayments, a balloon payment still requires you to make a large payment at the end of your car loan term. They also come with a higher amount of interest. This is why it’s important to weigh up whether the cost of lower monthly repayments is worth the savings.

How does a balloon payment work?

To get a better understanding of how a balloon payment on a car loan works, we’ve put together an example below.

Example:

Let’s say you want to purchase a $25,000 car and take out a car loan with a balloon payment of $7,500 (30% of the principal loan amount). This means you will pay off $13,000, plus interest, over the course of your loan term rather than the full $25,000. The last payment will be the lump sum amount of $7,500.

What is the difference between a balloon payment and a residual payment?

The terms ‘balloon payment’ and ‘residual payment’ are often used interchangeably. While they both refer to the lump sum paid at the end of a loan term, there are a few key differences between them.

A residual payment is more commonly associated with car leases, rather than car loans. It is calculated based on how much the vehicle will be worth after depreciation. On the other hand, a balloon payment is a set amount agreed upon by the lender and borrower and doesn’t take into account the fixed value of the car after depreciation.

Important things to consider before getting a balloon payment

Before you decide to take out a car loan with a balloon payment, it’s important to ask a few key questions. The most important thing to understand with a balloon payment is that while your monthly repayments are cheaper, the total cost of the loan actually ends up higher. This is because you have to repay the lump sum amount with interest when your loan term ends.

You’ll also need to consider how you will pay off the lump sum amount when it’s due. If you can’t pay it off at the end of the loan term, there might be a few options including refinancing on your current car or upgrading to a better car.

Key questions to ask:

• How much more interest will you be paying?
• Is the additional interest worth the short-term savings?
• How will you pay off the balloon payment at the end of the loan term?

What happens when the balloon payment is due?

It’s important to understand what happens when the balloon payment is due. Generally, there are a few options you can choose from. We give a quick rundown of each option below.

Pay the balloon amount

At the end of the loan term, you can simply pay out the balloon amount to your lender and then you’ll have total ownership of the car. Keep in mind that a balloon payment is usually quite a large amount, often between 30% to 50% of your principal loan amount.

Refinance

If you’re unable to settle the balloon amount, you might be able to refinance the amount with your current lender or a new one. While this can help keep your monthly repayments the same as your previous loan, making it more affordable, you may end up paying more in total interest.

Upgrade or sell your car

If you don’t want or need your car anymore, you can consider selling it and use the sale value to settle the balloon payment. Alternatively, you can upgrade your car and defer your balloon amount into a new car loan. Often, business owners refinance their car loan frequently, upgrading their vehicle each time.

What are the pros and cons of balloon payments?

To recap what we’ve discussed so far, we’ve listed some of the pros and cons of balloon payments below:

Pros

• Reduces monthly repayments: This is a key advantage of balloon payments. Because the balloon amount is deducted from your loan amount, your repayments are reduced.
• Flexible amount: Generally, there is flexibility when it comes to setting the balloon amount with a lender. While the typical percentage of the purchase price is between 30% to 50%, it can be more or less depending on your lender.
• Beneficial for business owners: A balloon payment is commonly offered through business car loans. This is because the lower monthly repayments can help with managing the short-term cash flow. Plus, the principal loan amount is non-deductible but business owners may be able to claim tax on the interest payments.

Cons

• Large payment at the end of loan term: It’s important to understand that if you choose a balloon payment, you’ll need to repay the lump sum at the end of the loan term. Make sure to consider how you will pay off the balloon whether that’s paying it, refinancing, selling or upgrading your vehicle.
• Higher amount of interest: While a balloon payment can reduce your monthly repayments, they do charge you a higher amount of interest over the term of the loan.

NODDLE is a consolidated online resource, we are not financial advisors. We work with a range of industry professionals and compliance check our articles to ensure factual accuracy. However, we do not provide professional financial advice. Consider seeking independent legal, financial, taxation or other advice to check how the information and ideas presented in this article relate to your unique circumstances.