A guide to reducing your car loan repayments by using a ‘balloon payment’ to borrow less money, save more money.
Car loan repayments can be crippling. We often assume a car loan when times are good and live to regret the ongoing repayment for many years to come.
You start wishing that you had of been smart enough to buy second hand (or slightly cheaper model) in order to release the cash flow you have caught up in your regular monthly car loan repayments.
While saving money on cars is quite the contradiction, the car loan itself holds the key to making the most of your situation, paying less interest and giving yourself the chance to save money.
Here is a guide to using balloon payments to save money and pay less with each car loan repayment.
What is a balloon payment?
A balloon repayment, often referred to as a ‘residual payment’, refers to a lump sum repayment you make at the end of your car loan term to pay off the car in full.
Essentially you are only borrowing a portion of the cars original value and promising to make a ‘balloon payment’ at the end of the car loan in order to own the car in full and repay the outstanding amount you didn’t borrow. This in turn lowers your car loan repayment on a regular basis and as a result, lowers the interest you pay over the loan term.
By using a balloon payment, you are able to free up cash flow and borrow less money.
What’s the catch? Nothing really, you just need to put away money over the car loan term to ensure you can afford the lump sum balloon repayment at the end.
Example of how a balloon payment works:
You buy a new car valued at $25,000. You opt for a 5 year car loan with a balloon of $5,000 (20%). As a result, you only need to borrow $20,000. Your interest and repayments are now lower as you did not borrow the full $25,000.
In doing the above, you now owe the car loan provider a lump sum of cash at the end of your agreed loan term. Come the end of 5 years you will be expected to make full payment of the ‘residual amount’.
Facts about car loan balloons:
- Balloon payments can be a set value $5,000 or a percentage of the borrowed car loan (20%).
- Balloon payments let you borrow less money, though don’t forget that a bad car loan interest rate can ruin that in a second.
- Some car loan providers will let you finance the remaining balloon payment if you are unable to repay.
- Each car loan provider will have a different maximum balloon they will allow.
- Most people don’t factor in how they will afford the balloon in the future resulting in trouble come time to repay.
Things you need to know about residual balloon payments
Balloon payments offer a convenient way to save money. The notion of paying less for a car loan and freeing up cash flow sounds too good to be true. In reality, it really is money for jam; however the biggest problem people face is that while they are saving money on their car loan, they forget to save for the balloon payment that seems a distant way off into the future.
This is why it’s critical to save for your balloon repayment ahead of time.
Further to this, people get carried away with the concept of saving money by reducing the amount you borrow. While this is important, the interest rate you receive on your car loan is the vital second element. Without a competitive interest rate to partner with your car balloon payment, you will not be able to get the best deal.
Ways to save for the balloon repayment
Save the portion of repayments you are not making
‘Save the savings’ and bank the money you would have otherwise paid in interest/repayments into a savings account or mortgage offset account. Come time to repay the balloon, you simply draw on your saved cash.
Double points for using the savings to do something smart like invest, earn interest or pay less interest on debt.
Make sure your balloon is less than the resale price of your car
A slightly risky strategy, though one many people use none the less. Set the balloon amount lower than the perceived resale value of the car in the future. This is hard as no one can predict resale value and it relies on you selling the car prior to the end of your car loan.
If you intend to do this, set a modest balloon payment and do your research to ensure the car will hold its value. Also start the sales process at least 3 months prior to the end of your car loan to ensure you are not forced to do a ‘fire sale’ in order to meet the balloon payment deadline.
Give yourself a repayment break; save rapidly in final years
If you are seeking a balloon payment to alleviate problematic cash flow, opt to give yourself a savings break but only if you pledge to repay the balloon via an aggressive savings strategy in the final one to two years.
So if your balloon is $5,000 and your car loan goes for 5 years, really you need to save $1,000 a year or roughly $84 a month. If you wait until the final 2 years, you have $2,500 a year to save or roughly $209 a month.