So you’re browsing finance deals, looking for your next dream car and you keep seeing the phrase ‘balloon payment’ or PCP (Personal Contract Purchase) payment crop up. What exactly does it mean? Well, a balloon payment is simply a lump sum paid at the end of a loan’s term that is larger than all of the payments made before it. Balloon payments allow those who are borrowing money to reduce the fixed payment amount in exchange for making a larger payment at the end of the loan’s term. This type of loan is usually for borrowers who have excellent credit and a substantial income but anyone can apply.
Balloon Payments Explained
Balloon payments or PCP finance offers a lower monthly payment scheme than traditional car loans or Hire Purchase. How it works is that you’ll have one big payment at the end of your contract which reduces the amount you pay monthly. PCP finance loans tend to be shorter than other loans.
Despite their reduced initial payments, balloon payment loans carry an element of risk due to the large payment at the end of the loan. Lenders usually only provide these types of loans to consumers with excellent credit, a substantial down payment and a stable income. Most car loans will ask for a large down payment to qualify for the loan.
How is a Balloon Payment Calculated?
When taking out a balloon payment the calculations you do are slightly different to a standard loan. For example:
Let’s say you buy a new car and borrow £40,000 over five years and elect to have a £10,000 (25%) balloon payment on your loan. Your monthly payments will be around £576 a month rather than £768 but you will still have to pay £10,000 at the end of your five-year contract.
The amount can be represented as an absolute pound value or a percentage of the borrowed amount. Except for leases, having a balloon payment on your loan is optional and your provider will be able to tell you if you qualify.
Our handy car loan calculator will help you determine what you are eligible for based on your income and assess various repayment amounts.
Balloon payments are not commonly used for car repayments as they are generally used for other purchases. However, lending restrictions are less stringent in the car loan industry so it’s a bit easier for consumers to take out this type of loan. Many enter into balloon car loans thinking that their income will increase with many people unable to pay the lump sum at the end.
While a balloon payment helps secure a lower monthly payment, consumers commonly take this loan out for the wrong reason. It’s important to remember that balloon payment loans aren’t actually more affordable, they simply spread the cost out in a different way. If there is no absolute guarantee that your income will rise, you should consider a loan that you can finance fully based on your current income.
What Happens When the Balloon Payment Is Due?
When it’s time to make the repayment, it’s crucial to plan for the lump-sum payment before you even take out the loan. Keep in mind that things don’t always work out as expected.
You can handle a balloon payment in a variety of ways.
- Refinance: When the balloon payment is due, one way to pay it off is to obtain another loan. In other words, you refinance. That loan will extend your repayment period by another 5-7 years. To be able to do this you need to qualify for another loan so your income, credit and assets needs to be in good shape when the balloon payment is due.
- Sell the asset: Another way to deal with the repayment is to sell off the asset your purchased with the loan. This is still assuming that the asset is still worth enough to cover the loan balance.
- Pay it off: If cash flow isn’t a problem, you can simply pay off the loan when it’s due. This isn’t always feasible as the loan can be tens of thousands of pounds. There may be situations where you can generate the cash you need before the balloon payment is due.
Pros and Cons of Loans with a Balloon Payment
Balloon payment loans are a complex financial product and should only be used by income-stable borrowers. For example, this type of loan would be a good choice for the investor who wishes to minimise short term loan costs to free up capital. For businesses, balloon payment loans can be used by companies who have immediate financing needs and predictable future income.
For the average borrower, you can take out a balloon loan if you know that your income will grow before the final instalment is due however if you’re looking to purchase a car or get a mortgage it might be a better idea to opt for a monthly payment based on your income. Alternatively, you can make a bigger down payment if you’re not in a hurry to make a purchase which will help you to lower the cost of your monthly repayments.
- Low or no initial payments
- Enables borrowers to access affordable short-term capital
- Can help cover financing gaps
- Costs of loan can be higher in the long term, especially if the loan is interest-only
- Poses more risk than traditional loans due to payment schedule
- There’s no guarantee that you’ll be granted a refinance to switch the debt obligation
Overall PCP loans are ideal for those who wish to change their car between 2 and 4 years. Find out more about the loans that we offer including PCP, on our Car Finance page.
Posted 12/11/2020 Back to Blog