Balloon payments are no party

Balloons normally conjure up images of birthday parties, happy times, and harmless fun. A balloon payment on a vehicle finance agreement, on the other hand, can potentially cost you a lot of money and destroy long-term wealth.

It is critically important to understand what a balloon payment is, how it works and the potential consequences of taking a balloon payment on your vehicle loan.

The aim of a balloon payment is to make the monthly repayments on a vehicle loan more affordable for you. You can think of a balloon payment as a lump sum that is payable at the end of your loan term.

With and without balloons
To illustrate this by way of an example, suppose two friends – Sam and Sam's Bestie - buy the identical car – costing them R400 000 each.

Sam and Sam's Bestie both take out vehicle finance*, but Sam's Bestie opts for a balloon payment of 20% of the price of the vehicle (or R80 000).

Sam's monthly repayments over the five-year period will be R8 500, while Sam's Bestie only pays R7 500.

Sam's Bestie feels pretty chuffed with a R1 000 extra to spend every month. At the end of the five-year term, however, Sam will owe nothing on the car, while Sam's Bestie will still owe the balloon payment of R80 000.

At the end of the term, Sam's Bestie will have paid approximately R18 000 more for the exact same car as Sam - see table.

There is more to consider when it comes to a balloon payment. Let’s assume Sam's Bestie does not have R80 000 available to settle his balloon payment at the end of the five-year term.

Sam's Bestie's bank graciously offers to extend his loan for another three years. This will, however cost R2 700 per month – meaning Sam's Bestie has paid almost R625 000 for a car that cost R400 000 eight years ago.

The real gut punch for Sam's Bestie, however, comes when the loan is paid off and the car can be sold.

After eight years of depreciation, Sam's Bestie's car is now only worth R170 000 – which effectively means a loss of R455 000 over the eight-year period. 

Sam's car will also depreciate, but he will have a paid up car a lot sooner than Sam's Bestie.

How to pop the balloon

There is, however, hope for Sam's Bestie and people who find themselves in a similar situation. If you currently have a balloon payment, the most-effective ways of popping the balloon are to follow one of the following tactics:

• Use any surplus funds that you might have to settle your debts quicker.
  
  
• Open a savings account to save up for when the balloon payment becomes due.

If you are in the market for a new vehicle, avoid balloon payments as far as possible.

It is also smart to try to save up for a healthy deposit.

It is crucial to only buy what you can afford. Generally, a vehicle is a depreciating asset. This effectively means you are borrowing money to fund something, the value of which, goes down as soon as you drive it off the showroom floor.

If you want to get a better understanding of vehicle finance and balloon payments, talk to a financial adviser - ideally one with the Certified Financial Planner accreditation - who will be able to explain the different options available to you in a simple and clear manner.