If you take out a conventional auto loan, you typically make repayments for a set number of months. At the end of the loan's term, you've paid back all the capital you borrowed and its interest. Balloon loans work differently, sharing some similarities with leasing agreements. You still make regular payments, but these only cover part of your borrowing. At the end of the loan, you owe your lender one larger payment, known as the balloon. If you're considering using this type of financing to buy an automobile, it's important to understand how it works and how it may affect your finances.
Balloon Payments and Amortization
A conventional loan typically amortizes fully over its term. For example, if you buy an automobile with a regular loan, your lender amortizes the full amount to calculate your monthly payments, dealing with interest first, then the money you borrowed. Lenders only partially amortize balloon loans, focusing on interest rather than capital repayment, because you set aside part of the money you borrow for repayment at the end of the loan. This makes your monthly payments lower, but you have to find a way to cover the remaining balloon debt when the loan matures.
Balloon Payment Options
You can simply make the final balloon payment when your loan matures to clear your debt and keep the vehicle. This is, however, not the only option. Some consumers sell their vehicles to fund the final payment; others refinance the balloon debt if they can’t cover its costs. Some lenders allow you to hand back the automobile in lieu of the balloon payment. You also may be able to trade it in for a different vehicle, taking on a new loan agreement.
Advantages of Balloon Payments
Your regular monthly payments are cheaper with a balloon loan, and you may not have to make a down payment. This may be an attractive option if you are short on cash in the short term but need to buy a vehicle. If you know that you'll have the money to cover the balloon payment when it is due or plan to sell or refinance the vehicle at that point, this could save you some money. Lower initial costs could also enable you to buy a more-expensive car on your budget than you could afford with a conventional loan.
Disadvantages of Balloon Payments
If you don't have a plan in place to fund the balloon payment when your loan matures, you could run into problems. You may have to sell or hand back the vehicle, leaving you without a car. If your vehicle isn't worth enough to cover the balloon payment, you'll need to find the cash to pay down the balance. If you can't do this, you could end up with credit problems. Although you may be able to refinance the vehicle, this will add to your overall costs and the time it takes to repay your debt. If your plan has always been to hand back the vehicle or to upgrade it, balloon financing may be more expensive than you thought. In this scenario, leasing a vehicle may be cheaper.
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