When I was in the retail auto business it was amazing how much time I spent explaining to customers what an auto finance balloon loan was and how that way of financing a vehicle actually worked.
A balloon car loan is a way of financing a car that’s structured in a way designed to reduce the monthly payments. This is done by setting aside a significant proportion of the auto loan to a large single payment that becomes due at the end of the agreement. It could reduce your monthly payment by a significant amount, but the money you save each month will still have to be paid at the end of the agreement and you could end up paying more interest as a result.
To fully explain this way of financing a vehicle purchase, I’m going to cover:
- What’s the point of a balloon payment?
- How an auto finance balloon payment works
- How an auto finance balloon payment is determined
- Negotiating an auto finance balloon payment
- What are the options when an auto finance balloon payment is due?
- Who does this type of finance suit?
- Advantages of balloon payment auto finance
- Disadvantages of balloon payments
- Difference between a balloon payment and a GFV
- Getting out of an auto finance balloon payment agreement
What’s the point of a balloon payment?
If you’ve never looked into balloon payment finance you might be wondering what the point is, and that’s a fair question. The whole reason for a balloon is to reduce the monthly payments to make purchasing a vehicle more affordable.
The balloon is a chunk of money you are not going to be making monthly repayments on, although you will still be paying interest on that part of the loan. If you think about buying a vehicle for $30,000 where you put down a deposit of $3,000, with a regular auto loan you’d then be repaying $27,000 plus interest. However, if the finance company sets a $10,000 balloon payment you’re then only repaying $17,000, plus interest on the whole $27,000, which is going to be more affordable than repaying the whole $27,000 plus interest.
Don’t forget though, the balloon payment doesn’t go away and you are still responsible for paying that amount in some way at the end of the agreement.
How an auto finance balloon payment works
Once you get your head around how a balloon payment finance agreements work, they’re not all that difficult to understand. The easiest way I know to explain them is to ask you to start thinking of the agreement as three separate parts. These parts are the down payment or deposit, the balloon, and repayment.
You put down a deposit as big or as small as you want, but I will say this sort of agreement is designed for those of us who don’t have or don’t want to put down a large deposit. If you do put a large deposit down and you stay with the balloon payment set by the finance company, you may not have any payments at all to make until the balloon is due. There’s nothing wrong with this, but it’s not really the point.
The part that’s left after the deposit and the balloon have been set is the balance, and this will be treated as a regular auto loan. This is the part you’ll be repaying with interest over 12, 24, 36, 48, 60 or even sometimes 72 months in some cases, which is the length of term you decide you want the agreement to run over. As well as the balance and interest on the balance you will also be paying interest on the balloon. The interest on the balloon is sometimes set at a different rate to the interest on the balance – often a lower rate – but don’t worry, it’s all bundled into a single monthly payment.
How an auto finance balloon payment is determined
How large a proportion of the vehicle price is offset as the balloon payment is determined by the finance company. The size of the balloon will usually be set according to the expected depreciation of the vehicle, but you can sometimes negotiate on this, and I’ll cover that in the next section.
The lender will use historical data to predict what the expected value of the vehicle will be by the end of the finance agreement term being proposed. The shorter the term, the larger the balloon payment will be. This can lead to some vehicles having more affordable payments than another vehicle with a higher sticker price. This is because the finance company might allow a bigger balloon on a Toyota Tundra than something like a Nissan Micra, even if the two models both have the same MSRP because the Toyota holds its value better.
Negotiating an auto finance balloon payment
In some circumstances, such as when you’re trying to get a monthly payment lower, you might want to try negotiating the size of the balloon payment. If you’ve got a strong credit history the finance company may be willing to increase the balloon a little from the level they’ve set it at. If they won’t and you still want to get the payment down, it might be worth asking the dealer to try a different company.
In my experience, different finance companies can sometimes put very different balloons on the same vehicle. The dealer is always going to want to get you taking finance through them so they should be happy to try and get you a bigger balloon elsewhere if the deal could depend on it. If they won’t or they don’t have another finance company to try, you can always shop online to get the finance from somewhere else yourself. You might even get a better rate than the dealer is offering too.
What are the options when an auto finance balloon payment is due?
If you get to the point where you’ve made all your monthly payments and the only thing left is the balloon payment, you do have options. The first and easiest option is to simply pay off the balloon, but if you stretched yourself to afford the monthly payments in the first place, the chances are you might not have thousands of dollars available to pay off the balloon.
You might not even want to pay off the balloon and keep the vehicle anyway, especially if you’ve had a lengthy agreement of 60 months or more. Whether you can’t pay the balloon or you don’t want to pay it, you can always trade the car in and let the dealer settle the balloon for you. If the vehicle is valued at more than the balloon you’ll get the difference back to you, but if it’s worth less than the balloon (which isn’t unusual) you’ll have to make up any shortfall.
If you do want to keep the vehicle when your monthly payments have all been made and the balloon payment is due, you also have to option of refinancing the balloon. The lender you’re already with may well be happy to arrange some alternative finance to fund the balloon, but you can go anywhere you want to get the appropriate funds to pay it off.
Once the balloon payment has been cleared the vehicle is yours unless the new finance is secured on the vehicle. If the finance for the balloon is secured on the car, you’re back to square one apart from your monthly payments will probably be lower.
Who does this type of finance suit?
The most obvious answer to the question of who this type of finance suits is anyone who wants to keep their monthly payments lower than they would be with a straight auto loan. I would add a little extra qualification to that though. I’d say this type of finance is only suitable for you if you do average miles per year or less. If you drive 15,000 miles per year or less you’re probably going to be fine with a balloon payment finance agreement, but if you do high miles you might want to think about other forms of funding.
The problem with this type of agreement if you do far more than average mileage is the potential value of your vehicle when the balloon is due. When the finance company decides the size of the balloon it will probably have been done by basing it on average mileage over the period of the agreement. If you do a lot more driving than the average, the vehicle is going to be worth a lot less than the balloon you’re going to have to pay at the end of the agreement.
That’s not a good situation to be in, and I’ve had a lot of very upset and angry customers in the past who’ve come to me to help them out in that sort of situation.
Advantages of balloon payment finance
As I’ve stated repeatedly here, a balloon payment finance deal will probably get you lower monthly payments than a standard auto loan and that’s the biggest advantage. Another advantage over some other forms of auto finance is you can sell your vehicle and get out of the agreement at any point if you want or need to.
With this type of agreement, you are also not limited to the number of miles you drive in your vehicle over the term of the agreement, although there is that issue of the value when you come to sell. The agreement also has fixed monthly payments so you know exactly how much you are going to be paying every month which makes budgeting easier.
Perhaps the main advantage this type of agreement has in the eyes of the consumer is it allows them to get a better vehicle for their budget than they might be able to afford otherwise.
Disadvantages of balloon payments
Like most auto finance, if you want to sell your vehicle before the end of the agreement it’s going to be expensive, and negative equity is a common problem. But even before you take out an agreement you might find your choice of vehicle limited if you’re intent on buying with this type of finance.
It can differ quite considerably from lender to lender, but they will all lace their own restrictions on what vehicles they will allow you to buy with this type of finance. There will be restrictions on how old the vehicle can be when you buy it and how old it can be by the end of the proposed agreement. This could rule out a vehicle you’re already looking at if it’s too old or has too many miles on the odometer, and it could limit the length of agreement available on a particular vehicle to a shorter term than you’d like or can afford.
Difference between a balloon and a GFV
You may come across a similar type of agreement to balloon finance called a Personal Contract Purchase (PCP) that has a balloon called a GFV. A GFV is a guaranteed future value, and in a lot of ways, it’s almost the same as a balloon. The only difference between the two is the GFV is a guarantee from the finance company that you won’t have to put up with a vehicle that’s worth less than the balloon at the end of the agreement.
Now, stick with me here because this is a contentious subject that I’ve seen cause more arguments in showrooms than just about anything else. The difference between a balloon and a GFV is that if you come to the end of the agreement and you have a GFV, and the vehicle is worth less than the GFV, you can hand the vehicle back to the finance company and you’re debt is cleared. With a balloon, you do not have that option and you are responsible for any shortfall.
However, unlike a balloon, a GFV is set at the beginning of the agreement based on a maximum amount of mileage you say you are going to do. If you come to the end of the term and you’ve done more miles than allowed under the agreement, there will be a mileage charge of so many cents-per-mile for the amount you’ve done over the agreed amount if you want to hand the vehicle back. There will also be additional charges to pay to hand the vehicle back if the condition is worse than set down in the finance company’s fair wear and tear guidelines.
In some ways it’s a lot like a lease, but easier to get out of early because it’s more flexible. The big problem with this type of agreement is a lot of customers simply don’t understand them, and some go away with the idea that at the end of the agreement the finance company pays them the GFV!
Like any type of finance agreement, balloon agreements have their pros and cons and it’s up to you to look into them properly and decide if they are for you.