/ 1 October 2010

# The real cost of a balloon payment

Ntswaki asks: I am 25 and planning on buying my first brand new car (a Mini Cooper to be specific). I am really excited about it, but I only have the R10Â 000 deposit thus far.

I have been quoted R220Â 000 for a new Mini with a balloon repayment of about 40% and I can afford it. My dad is discouraging me, saying the balloon repayment can be problematic in the future.

I cannot wait until I start earning R20Â 000 per month. I don’t want any other car, but a Mini. How bad can a balloon repayment option be? Should I or shouldn’t I go ahead and buy the car? I am really confused. Even used Minis cost around R190 to 200k.

Maya replies: Ooh, the temptation to buy the car of your dreams. Unfortunately I am going to have to side with your dad on this one.

You ask “how bad can a balloon repayment be?”. Bad, very bad. For clarity, a balloon payment or residual payment is only paid at the end of the loan period and you continue to pay interest on it.

Let’s do some maths.

The value of the car
The second you drive your Mini out of the dealership it falls in value. Apparently Mini Coopers hold their value better than most. Based on historic depreciation values of Mini Coopers, after three years your car will have fallen by 33% in value. That means you would have lost R72Â 600 in value.

I am assuming the dealer offered you a repayment period of 72 months (six years) in order to make the repayments even lower. It is safe to assume that after six years your car would have lost 50% of its value and would be worth R110Â 000.

The value of the balloon payment
A 40% balloon repayment means that you have a debt of R88Â 000 which you are not paying off. This means you are paying interest on R88Â for six years. At an interest rate of 11,5% (I have assumed 2% above prime) you will pay R87Â 000 in interest on that R88Â 000 balloon payment over 72 months.

Not only have you now paid the equivalent of the residual payment in interest, but you now have to pay the R88Â 000 lump sum. Either you will have to sell the car or you will have to re-finance it for another few years. You will be paying this car off for longer than you want to be driving it.

The premise that you can afford the car is incorrect unless you believe that you will discover R88Â 000 sitting in your bank account in six years’ time.

The temptation to have the car right now is very great. Who wouldn’t want to climb into that sexy car if they had half a chance?

What I can say with conviction is that in six to 10 years’ time when you are in your thirties, starting a family and wanting to buy a home, you will regret this decision.

According to the banks, the single biggest reason people get turned down for a home loan is because of their car debt. Opting for a less expensive car could mean the difference between being turned down for a home loan or having the deposit to buy your first home.

Read more news, blogs, tips and Q&As in our Smart Money section. Post questions on the site for independent and researched information.