/ 27 June 2011

Getting wise to the dangers of balloon payments

Last year, Smart Money advised readers against opting for a balloon payment when financing a new vehicle.

The good news is that consumers seem to be getting wise to the dangers. According to data from WesBank, the number of consumers opting for a balloon payment has dropped from 22% in July 2007 to 9,5% in June 2011 — quite a significant number.

Why are balloon payments dangerous? Simply put, although a balloon payment makes your dream car affordable, you end up paying heavy interest because this payment is only paid at the end of the loan period. Yes, it can reduce your monthly instalments, but in the long term you end up paying much more than you anticipated and can probably afford.

A balloon payment will take longer to reach break-even — the point at which the amount owing on a car is equal to what the vehicle can be traded for. A vehicle financed over 72 months, with no balloon payment, would break even at 44 months. With a 20% balloon payment, you would only look at breaking even at 58 months. A vehicle financed over 72 months with a 10% balloon payment will increase the consumer’s interest cost by 8% — quite heavy!

Chris de Kock, head of sales and marketing at Wesbank, warns that consumers must have the payment for the asset on hand, too. If they don’t have the cash to make the final payment, the buyer can choose to refinance the balloon payment or trade in the vehicle, so the balloon payment will be settled and the consumer can enter a new finance agreement.

“As long as the consumer has a clear understanding of how long they intend to keep the vehicle, then the finance agreement can be structured intelligently to ensure the consumer can trade out of the vehicle at that point,” De Kock says.

A well-structured balloon payment has to ensure that a vehicle is worth the same or more than the balloon payment amount at the end of the contract. It should not be a burden to the customer. However, about 65% of WesBank’s customers on balloon payment structures will ask to re-finance the balloon on termination.

De Kock suggests that customers consult a reputable dealer who can give advice regarding which financing option is best suited to their circumstances.

Happily, consumers are becoming more aware of the structure of their finance deals and are also showing better credit sense, purchasing within their means. In fact, South Africans are opting to buy more affordable cars, which is a more realistic way to survive in tough times.

De Kock says the introduction of the National Credit Act (NCA) has also stopped people from opting for balloon payments, because the Act allows for longer-term contracts, so consumers can pay off a vehicle comfortably. The average contract period has moved from 50 months (before the NCA came into effect) to the current 66 months, with deal durations increasing from an average 29 months to 45 months.

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