Financing a balloon payment, improves your cash flow & enables you to upgrade to a better model of car.
Car Finance Balloon Payment Explained
Including a Balloon Payment or Residual Value in your loan or lease can be a good idea to lower your monthly repayments and enable you to purchase a better model of car.
Structured finance for motor vehicles has usually been confined to commercial car loans and car leases, but incorporating a balloon payment, or residual value, into consumer car loans is increasing in popularity for those borrowers that understand how they work and that have a good credit history.
What is the Residual Value of an Asset?
The residual value of a car, or light commercial, is an estimate of the value of the asset at the end of finance lease, or at the end of its useful life.
As a general rule, the longer the useful life or lease period of an asset, the lower its residual value.
When leasing an asset, the quantum of the residual value impacts the cash flow of the obligor both during the term of the lease and when the residual value falls due.
In the world of structured finance, the residual value is also referred to as the RV, Residual Payment, Balloon Payment, or simply Balloon.
RV’s are usually represented as an absolute dollar value or a percentage of the value of the cash price of the goods. Except for finance leases, the inclusion of a residual value or balloon payment is optional and usually the domain of commercial finance transactions.
How do Residual Values or Balloon Payments work?
With a standard loan, you make a set number of principal and interest repayments that results in the total amount of the loan being repaid by the end of the term. At that stage you owe nothing and own the asset.
However, with a structured loan or lease, there is usually a large “lump sum” payable at the end of the loan or lease that typically equates to the residual value of the asset. This is the residual value or balloon payment.
Incorporating a residual value or balloon payment into a loan/lease reduces the monthly repayments payable to the financier. In effect this is a deferral of a portion of the principal owing to the end of term which helps to improve the cash flow of the borrower. However, it means the borrower will owe the financier the lump sum at the end of the loan or lease term.
Financing a balloon payment, improves your cash flow & enables you to upgrade to a better model of car.
At AFS, we offer four (4) business finance products types for you to finance your car our light commercial.
Option 1: Loan with No Balloon
Customer X wants to purchase a new car for $30,000 over 5 years and own the car at the end. They have a great credit rating and almost own their home and therefore qualify for a base rate of 6.97%. The monthly repayments in this example are $611.42. Once 60 payments have been made, there is nothing more to pay and Customer X owns the car.
Option 2: Loan with 30% Balloon
The same customer is also given the option of a 30% balloon payment at the end of the loan term. This means that they will have to pay $9,000 at the end of the loan in order to own the car. However, structuring the loan with a balloon results in monthly repayments of $485.55 – a reduction of $125.87 per month!
Benefits of Balloon Payments
The inclusion of a residual value or balloon payment into the structure of a loan or lease, has many benefits, including:
How do you set the amount of the Residual Value/Balloon Payment?
The residual value of a car, or light commercial, should be no less than the estimated value of the asset at the end of finance lease.
Key to determining a vehicle's resale value at the end of the loan term will be the kilometres travelled. If the estimated travel is more than the approximately 15,000 to 20,000 kilometres travelled by the "average" driver annually, the expected resale value and Residual Value/Balloon Payment may need to be adjusted.
The reverse is also true - a vehicle expected to travel less than the average could reasonably be expected to retain a greater percentage of its original value. For leases, the Australian Tax Office (ATO) imposes a minimum percentage value of the cost or cash price of the goods for a range of lease terms.The ATO minimum applies to all lease types including finance lease, novated lease, personal lease and fully maintained novated lease.
When structuring a lease, remember that the lower the residual value (subject to the ATO minimum percentage values), the less interest you pay. Whilst this may increase your monthly payment, it does increase the available tax deduction for the lessee.
For more information about the ATO guidelines for minimum residual values, click here.
The are no minimum balloon payment guidelines set by the ATO for other loan types, but each finance company will set their own. To understand more about AFS’ balloon payment guidelines, click here.
What to do when your Balloon Payment falls due?
As your car loan approaches maturity you need to decide between the following options that are available to you:
Refinancing a Balloon Payment or Residual is available on the same terms as those for any new or used car and the interest rate will be based on your updated credit profile.
Your original Balloon Payment can be anywhere from 0%-55% of the purchase price, depending on the term, which you can refinance over another 1-5 years. You can also choose to structure the new loan or lease to incorporate a new Balloon Payment if you wish.
At AFS, we are happy to assess any request to refinance your loan before the Balloon Payment is due. Ideally, we'd like to get things underway a few months prior to the Balloon falling due, giving you plenty of time to search for your new car.
Extra Interest?
You pay more interest on your loan when you have a balloon payment. That’s because you’re effectively paying interest on the value of the residual value or balloon payment for the entire term of the loan.
A key benefit of having a RV or balloon payment is lower monthly repayments. But the corollary of this is that the outstanding principal balance of the loan or lease will be higher throughout the term of the loan/lease - due to the lower monthly repayments - resulting in higher interest charges.
Extra Interest Example
In the two examples provided above, the inclusion of a 30% balloon in Option 2 results in the customer paying $8,133 in interest rather than $6,685.20 in interest under Option 1 – an additional interest bill of $1,447.80!
This is effectively the trade-off to consider between having and not having a RV or balloon payment.
A simple takeaway is the lower the balloon payment the less interest you pay.