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Understanding Balloon Payments in Car Financing: Pros, Cons, and Everything in Between
Car financing is a popular option for purchasing a new or used vehicle. While there are many different types of car loans, one term that often comes up is “balloon payment.” In this article, we will discuss a balloon payment in car financing and how it works.
What is a balloon payment?
A balloon payment is a large, lump sum payment due at the end of a car loan term. Also known as a ‘residual payment’, this payment is typically much larger than the monthly payments made during the loan term. Balloon payments feature heavily in personal contract purchase (PCP) agreements.
What are PCP agreements?
PCP stands for Personal Contract Purchase and is a type of car finance that allows you to make lower monthly payments by deferring a portion of the car’s value until the end of the agreement. The deferred amount is known as the balloon payment.
In a PCP agreement, you agree to pay a fixed monthly amount for a set period, typically two to four years. At the end of this period, you have three options:
- Return the car to the dealer and walk away. If the car is in good condition and you haven’t exceeded the agreed mileage limit, you won’t owe anything else.
- Keep the car by paying the balloon payment. This is a large, one-off payment that represents the deferred amount of the car’s value. You can either pay the balloon payment in full or refinance it.
- Trade the car in for a new one. If the car is worth more than the balloon payment, you can use the difference as a deposit on a new PCP agreement. If the car is worth less than the balloon payment, you’ll need to make up the difference.
The reason why PCP agreements have a balloon payment is to make the monthly payments more affordable. By deferring a portion of the car’s value until the end of the agreement, you’re effectively paying less each month.
How does a balloon payment work in car financing?
When you take out a car loan with a balloon payment, you will make smaller monthly payments during the loan term, typically three to five years. These payments will only cover the interest on the loan and a portion of the principal amount. At the end of the loan term, you will need to make a large payment to cover the remaining principal amount of the loan, which is the balloon payment. When you enter into a balloon payment agreement, the residual sum and prices will never change, so you can budget with the safety of repayments remaining the same.
Balloon payments are available to customers with a strong credit rating who can provide a large down payment. A strong credit rating indicates trust, which is essential in a balloon payment loan, where the lender places faith in the customer’s ability to pay a sizeable residual sum.
Why would someone choose a balloon payment?
The main reason someone might choose a balloon payment is to have lower monthly payments during the loan term. This suits people who want the car but want to avoid paying a substantial amount upfront and can use the period of the loan term to save the money necessary to make a final payment. The lower monthly payments can also make it easier to qualify for a loan, as the lender will look at your debt-to-income ratio, which is based on your monthly expenses.
Additionally, someone might choose a balloon payment if they plan to sell the vehicle before the end of the loan term. This can help them keep their monthly payments low while they own the car and allow them to pay off the remaining balance when they sell it. Be careful when selling your financed car, make sure you check with your car finance provider to ensure you are legally available to do this.
Are there any risks associated with a balloon payment?
While a balloon payment can be helpful for some, it comes with some risks. The main risk is that the final price becomes unfeasible during the loan term, and you are subsequently left in a position where you can’t afford to pay off your loan.
If you plan to keep the vehicle at the end of the loan term, you must come up with the balloon payment. You may need to refinance the loan or sell the car if you cannot afford this payment.
Another risk is that you will pay more in interest over the life of the loan. Since you only make small monthly payments during the loan term, you will accrue interest on the total principal amount for a more extended period. This can add up to a significant amount of interest over the life of the loan.
A balloon payment is a large, lump sum payment due at the end of a car loan term. As with any loan agreement, there are positives and negatives; whether it suits you depends on your circumstances. Suppose you are considering a car loan with a balloon payment. In that case, it is essential to carefully consider your financial situation and ensure you are prepared for the balloon payment at the end of the loan term; otherwise, you will be left in a significantly difficult financial position.
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With Marsh, you can apply for car finance and check if you’re pre-approved without impacting your credit score. Plus, you’ll receive a decision on the same day. Don’t let a balloon payment hold you back from driving away in your dream car. Apply now with Marsh Finance!
Representative example: borrowing £10,000 over 60 Months with a representative of 17.9% APR, an annual interest rate of 17.9% (fixed) and a deposit of £0.00, the amount payable would be 59 repayments of £246.25 per month, with one final repayment of £256.25 (which includes the option to purchase fee of £10.00), with a total cost of credit of £4,785.00 and a total amount payable of £14,785.00.