With interest rates rising, inflation, tight inventory, and vehicle prices stubbornly high, automakers continue to look for ways to lure buyers. Lately, they’re resorting to an old financing tactic known as balloon payment car loans.
This resurgence emerges to combat market factors and entice vehicle buyers to get off the couch to buy. Balloon loans, or those with low monthly payments and one giant one at the end, never really disappeared. However, they fell out of favor with the housing market’s collapse in 2009 when balloon mortgages became one of the culprits in the housing crash.
For vehicles, captive finance companies of several vehicle brands offer some version of balloon payment loans. Banks, credit unions, and other lenders offer them, too. For you as a car buyer, is that good or bad? How do they work?
What is a Balloon Payment?
A balloon payment loan allows the borrower to pay part of the cost of a car, along with interest on the total price, during the loan term. The term can be 24 months, 36 months, 48 months, or longer, just like a traditional loan. Some lenders may restrict the length of the payment plan. For example, Acura Leadership Purchase Plan only offers 24 to 48 months. Then at the end of the term, the remainder (balloon payment) of the original cost or balance is due.
Because a balloon payment loan leaves a chunk of the vehicle’s original cost for the borrower to pay at the end of the loan, the monthly payments on the rest are lower. Depending on the price of the vehicle, the monthly savings can be $100 or more.
Although a balloon payment loan often gets compared to a car lease, they have little in common beyond offering a lower monthly payment than a traditional automotive loan. Later, we’ll compare vehicle balloon payment loans with leasing and conventional loans.
How Does a Balloon Payment Loan Work?
The shopping and buying process for the vehicle is the same as for a lease or traditional loan. The lender will usually require some down payment in cash or a trade-in with some equity. As a savvy shopper, you will negotiate your best deal on the purchase price. With that settled, you and the lender will determine the number of months or the term of the agreement. The lender will set the balloon payment amount and finance the remainder for the agreed-upon loan term.
The financing company will base your monthly payment on the loan term, the interest rate on the balloon payment, and the amount financed. Sometimes the balloon payment interest rate will differ from the funded amount. It sounds more complicated than it is in reality. The interest on the balloon loan gets factored into the monthly payment.
At the end of the term, you will be on the hook for the balloon payment, which you either pay in cash or by refinancing the balloon amount. In a standard car balloon payment loan, the lender will require you to decide on an option. The lender will treat the balloon amount as a default if you can’t pay. It will affect your credit standing the same as not making the monthly payments on a traditional loan or lease. In other words, it’s like having an automobile repossessed.
There is a form of balloon payment loan with a guaranteed buyback that is much less scary. Read on to learn more on that.
Balloon Loans vs. Traditional Loans
Car buyers will find that balloon and traditional loans get done the same way. You shop and negotiate for them in the same manner. Also, you own the vehicle when you successfully fulfill the terms of the agreement.
A traditional loan’s advantage over a balloon loan is that while you make the monthly payments on the conventional loan, you don’t need to worry about excessive mileage or wear and tear. If you plan to refinance the balloon amount, that may not be the case with the balloon payment loan. Financing the balloon amount may entail a lender inspection. At that point, if the car’s value comes in less than the balloon amount, financing may be problematic.
On the other hand, you could trade in the vehicle rather than pay off the balloon. The issue here: Is the vehicle worth as much or more than the balloon amount? If it is, you are still okay. If not, you may need to put up some cash to make up the difference or have the dealer roll the negative amount into the financing on the next vehicle. That can be costly in excess interest over a more extended period.
The most significant advantage of a balloon loan is lower monthly payments. How much lower will depend on the size of the balloon amount, the interest rate(s), etc. However, $100 a month less is a good guess.
Balloon Loans vs. Leasing
There are similarities between balloon payment loans for cars and leasing. Both provide lower monthly payments. Leasing is more like renting than buying because you can walk away at the end of the monthly payments. Lenders will base monthly lease payments on the vehicle’s depreciation during the leasing term.
When computing a lease’s monthly payment, the lender estimates the vehicle’s value at the end of the lease. They will base monthly payments on the original selling price minus the estimated value at the lease’s end. You have no further obligation if you return a leased car at the end of the term in good shape and with the agreed-upon mileage. Of course, you don’t have any transportation either unless you purchase the vehicle in a buyback.
With a standard balloon payment car loan, you still must settle the balloon amount at the end of the monthly payments. You can’t just hand the vehicle back without satisfying the outstanding balance. At this point, it’s like leasing when the leasing party decides to buy the car rather than turn it in. However, the leasing party can purchase the vehicle or not. The car balloon payment borrower has no choice but to pay or finance the balloon.
Pros and Cons of Balloon Payment Loans
Here’s what you need to weigh in deciding whether to take a balloon payment loan for your auto financing option.
Pros
- Lower monthly payment: You will almost always have a lower monthly payment with a balloon payment loan than with a traditional loan. It can be as much as $100 or more.
- Ownership rights: A significant advantage of vehicle balloon payment loans offer over leasing is that you can sell or trade the vehicle to get out of the balloon payment. Although your lease may permit you to transfer the lease to someone else, you can’t sell it or trade it in to escape the lease. It’s not your car.
- Upkeep: Unlike a lease, you don’t need to fret about mileage or wear and tear with a balloon payment loan. This is particularly true if you don’t intend to trade in or refinance the vehicle at the end of the monthly payments.
Cons
- Balloon payment: The smaller monthly payments transform into a considerable final amount. If you haven’t created a workable plan to address this reality, facing down that balloon payment will be like hitting a wall.
- Qualifying vehicles: Even captive lenders won’t always offer car balloon loans on every one of a brand’s models. Securing this type of financing may limit your choice of models.
- Upside-down: Odds are your vehicle will be worth less than the balloon amount when payment time arrives, known as being “upside-down” in the loan. This status will make financing the balloon amount harder and may require another down payment to make up the difference. You would have a similar problem with a traditional loan if you used the vehicle as a trade much before the last few months of the loan term.
Guaranteed Future Value Twist
Some captive finance companies offer balloon loans with a balloon payment based on the vehicle’s estimated residual value at the end of the monthly payments. Often called GFVs (Guaranteed Future Value), these loans have a balloon payment equal to the projected value of the car at the end of the monthly payment term. GVRs are much closer to leases than balloon payment loans because you can return the vehicle at the end.
As with a lease, the monthly payments are usually less than those of a traditional car loan because you only pay for the car’s lost value during the GVR term. However, the catch here is that, as a lease, there will be a cap on the number of miles you can drive. Moreover, you will need to return the vehicle in very good condition. Violating either of those provisions will cost you extra money when returning the vehicle.
Audi Premier Purchase, Ford Options, Acura Leadership Purchase Plan, and Hyundai Evolve Retail are among the balloon payment car loans allowing you to return the vehicle when the monthly payment term ends.
Are Balloon Payment Loans a Good Idea?
Balloon payment car loans do not make sense to take on. If conditions require you to buy a vehicle right now and you need a balloon payment loan to make the monthly payments work within your budget, maybe. However, we would urge you to explore every other avenue first. Buying a cheaper car makes more sense. If you finance your vehicle with a balloon payment loan, create a plan to satisfy the balloon payment before signing the agreement.
Suppose you can’t afford to pay the balloon amount today. In that case, chances are pretty good you won’t be able to cover it two, three, or four years from now, especially given today’s uncertain economic conditions. Your monthly payments will be a little steeper, but guaranteed future value loans provide some peace of mind knowing you can turn the vehicle in if you can’t cover the balloon payment.
