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When negotiation a car loan with your financier, one of the important decisions faced with is whether you wish to have a ‘Residual Value’ or ‘Balloon Payment’ on the loan. These terms, which are essentially the same thing, are very often grossly misunderstood by consumers and deserve to be looked at closely:
Having a Residual Value/Balloon Payment and the size of it affects the amount of your regular monthly repayments and allows you to pay a much lower instalment during the first few years, while driving a car you wouldn’t otherwise be able to afford. Sounds like a great concept, but many car buyers have fallen victim to the less transparent negative aspects that such a loan entails.
How does it work?
In simple terms, instead of spreading the full vehicle price over a normal finance period like four or five years, you defer a percentage, say 30%, of that lump sum to the end of your finance period.
This then allows for a much lower monthly instalment during the normal finance period, but you still face the 30% ‘balloon’ payment (residual value) at the end of the loan term. The balloon payment or residual amount can then be refinanced, or you have to pay in the outstanding lump sum by paying cash or selling the car!
For example: A new car buyer borrows R200,000 over 5 years and elects to have a R50,000 (25%) Residual Value/Balloon Payment on their loan. Their monthly repayments will be significantly lower than if they had no Residual Value/Balloon Payment, however they will still owe the bank the R50,000 at the end of the finance period.
Remember: Having a balloon payment means that you have an additional debt (R50,000 as in the example above) which you are NOT paying off, but you ARE paying interest on it over the full loan term. Thus, over 5 years, at an average interest rate you could pay about R40 000 in interest on that R50,000 balloon payment! At the end of the loan term, not only have you paid almost the equivalent of the balloon payment in interest, but you now have to pay the R50,000 lump sum as well.