What is a balloon payment, and how do they work?

When you take out a car loan or mortgage that has a balloon payment, it means you will have to make a large payment at the end of the loan term. For instance, let’s say you take out a car loan for R120 000 with a repayment period of five years. If you make smaller payments that only cover 80% of the loan, your balloon payment will be R24 000.

Characteristics

• It’s only due at the end of the loan term
• It’s much larger than your monthly loan payments (more than double). Hence the term “balloon.”
• The balloon payment amount is subject to interest over the life of the loan

How to pay off a balloon payment

South African borrowers have three main options:

• Make a lump sum payment. If you have managed to save over your loan term, you simply pay off the balloon payment once it’s due.
• Sell the asset. For instance, if you have a balloon payment car loan, you can sell the car you bought with the loan. You then use the money from the sale to pay off the balance.
• Refinance. This means taking out a loan which will have advantageous repayment terms compared to the actual one.

Pros of balloon payments

• Reduces your monthly payments. Your loan will have lower monthly payments than a traditional loan. This makes the loan more affordable initially.
• Leaves you with more disposable income. Because you don’t have to make large payments for several years, you have more room in your budget for other expenses.
• A deposit is not required. You usually don’t have to make a deposit. Again this allows you to purchase what you want sooner by taking out a loan you would not otherwise afford.
• Gives you time to improve your financial situation. Since you have several years before the balloon payment is due, you have more time to build up your savings and boost your income.

Cons of balloon payments

• Usually required after a short term. Balloon loans sometimes have shorter terms than traditional loans. Therefore, you may not have enough time to save for it properly.
• The lump sum payment can be unaffordable. It’s easy to take out a loan with a balloon payment, thinking your financial situation will improve down the line. This is risky because if nothing changes, you may struggle to pay off the balloon payment.
• The loan can end up being more expensive. Because you are paying interest on the balloon payment over the life of the loan, the total cost of the loan can be higher than a traditional loan.
• No guarantee of a refinance. If you’re unable to refinance, you’ll have to cover the balloon payment. Even if you sell the asset you spent the loan on, you’re still liable for any shortfalls.