What are Balloon Payments?
Buying a car or a piece of machinery for your business involves diving into the world of Asset Finance. When talking to banks or finance brokers, you’ll often hear them use the term ‘balloon payment’, or ‘residual’ when describing the arrangements at the end of a loan term. The terms can seem confusing, but what do they mean?
Firstly, asset Finance is a broad term describing the range of financing options used to acquire vehicles, boats, caravans, machinery, office equipment and household items like TV’s and computers.
Balloon or residual payments are used to reduce the normal monthly repayment amount by deferring part of the loan to the end of the term.
The actual balloon payment is a lump sum amount paid as part of the final repayment. It’s most commonly used with vehicle loans for businesses, but is also available with some assets purchased for personal use.
Commonly, balloon amounts equate to a percentage (e.g. 10%, 20% or even 30%) of the purchase price, and have the effect of reducing the repayments during the loan term. The customer has the choice of paying out the balloon, or refinancing it into another loan (e.g. personal loan), or selling the asset to pay it out.
So, let’s bring all this information together into a simple example:
Jane purchases a vehicle for her small business. The purchase price is $40,000. Jane decides to take a loan with a 5-year term. Without a balloon arrangement, the repayments would be calculated on the full $40,000. Jane wants to reduce the impact of the repayments on her cash flow, so she takes the loan with a 20% balloon. Jane’s repayments would be calculated on $32,000 instead of $40,000, and thereby reducing the normal monthly repayments. In 5 year’s time, Jane would need to pay out that remaining 20% ($8,000) in her final repayment. If she didn’t have the funds at the time, Jane would have the option of applying to refinance the balloon into a standard personal loan or another financing arrangement.
There are benefits and other matters (e.g. taxation) to consider before committing to a balloon payment, so it is important to seek appropriate advice from your accountant or financial advisor. Like any finance option, you need to determine if it’s suitable for your circumstances.