Is balloon payment option a good idea?

Recently I had a chat with a colleague.  She drives 2014 Merdeces Benz C200. She is planning on getting a new car and wants to sell the Mercedes to raise a decent a deposit for a new set of wheels. I asked if the car has a balloon payment – she was not sure. She would soon learn that she does not have a car to sell, as there was 40% balloon payment payable if she wanted to own the car. It was all in the fine print.

A balloon finance (also known as residual) is a type of financing arrangement that guarantees lower monthly payments in exchange for a larger one-off/balloon payment at the end of the finance term.

There are two types of balloon payments/residuals, the ownership residual and the non-ownership residual. With an ownership residual, you are responsible for the balloon payment at the end of the term. With a non-ownership scenario, the financier still owns the car at the end of the term and takes responsibility for re-selling it to cover the balloon payment. With non-ownership the financier will put restrictions on your use of the vehicle to keep mileage low and the vehicle in good condition to maintain value. It’s essentially a lease arrangement. So it is important to read the fine print.

Balloon payments contract allows you to ‘buy’ a car that you can otherwise not afford. While this may be ideal in the short term, it may have negative impact on your finances in future. Balloon payment finance arrangement has pros and cons for buyers depending on circumstances of each buyer.

Think of a candidate attorney, trainee accountant or cadet engineer, who may believe they have a chance of earning a decent salary post training – that is if they ever get a job in South Africa. All they want to do is to get wheels to move from client A to client B. Let’s be honest, those traineeships are a glorified form of slavery. 16-hour days, night shifts, at a minimum wage. I digress.

The point is, they would want to keep vehicle costs at a minimum. Perhaps balloon payments contracts better suit such people. In this way, they can afford to pay minimum instalments (rentals) on car they could otherwise not afford. At the end of the traineeship they could take the car back and hopefully afford something decent.  After all, a five year old car that is out of motor plan or maintenance plan is not good for your wallet.

It’s important to note that the car belongs to the financier until you have paid the balloon payment.

At end of the term you may have the following options depending on the deal structure:

• Pay the balloon payment and keep the vehicle
• Return the vehicle to help pay down the remaining balance on the loan. However, if the value of the car doesn’t cover the balloon payment, you may still be liable for the balance.
• Trade in the vehicle for a new vehicle. Depending on the deal, you may still be responsible for some additional payment to make up for the shortfall.
• You may decide to refinance the balloon payment at the end of the term. This will extend your debt, you will incur more interest and charges, on an old car

Lately the marketers have re-engineered the balloon payment arrangement and gave it a fancy name – Guaranteed Future Value. GFV is when the financier guarantees the minimum future residual value of the vehicle, regardless of its real depreciation. In theory, if the car drops in value more than was expected, the financier will incur any shortfall.

The popular catch phrase ‘drive a new car every three years’, really means ‘we want you to enter into perpetual car rental agreement’.

There are rules to this and you must keep to the rules if you are to have a happy ending. Or at least an expected ending.  These rule include restrictions on the number of kilometres you can travel each year, keeping to the service plan and keeping the vehicle in good condition – no chips and dents. You must choose the deposit amount. The bigger the deposit the lower you’ll pay in instalments.

Some may feel there are too many rules and restrictions with GFV and that there is no real freedom associated with owning a car. This feeling is not misplaced, you don’t own the car – you’re renting it.

So what happens at the end of the term? It is important that you do not exceed the vehicle mileage, that you keep the vehicle in good condition, save for ‘fair wear and tear’ and service the vehicle in terms of the manufacturer’s service intervals.

These are the common options offered at the end of term:

• Return the vehicle and go home. If the vehicle is in good condition, set kilometres not exceeded, service accordingly, you have no further obligations.
• Upgrade to new vehicle – If the trade-in value if is higher than the GFV, you can pay the excess as deposit for the new car.
• You can keep the car and pay the Guaranteed Future Value amount.

Some people may want to keep the vehicle after the repayment period. People develop emotional attachment to the vehicle. After all, we are emotional beings. You have looked after your vehicle so well and may have even pimped it a little.  You want to hold on to that bakkie because it’s so reliable, low maintenance and has never let you down. You have no trouble paying the high instalments. If you’re are this person, you may want to keep to the traditional 60 months flat repayment arrangement.

So, before you decide on the next set of wheels, don’t take on the word of the salesman. Their aim is to maximize sales. There is always a catch with those low instalments. Do some research and choose an option that is best suited for you – there are pros and cons to every deal structure.