When it comes to buying a car, many people turn to car finance as a convenient option to spread the cost – and may come across the concept of balloon payments in the process. But what exactly are balloon payments and how do they work?
What is a balloon payment?
A balloon payment is a lump sum payment that’s due at the end of a personal contract purchase finance (PCP) agreement.
Bigger than all the payments that came before it, it’s the final payment that you make if you wish to keep the car when the loan term finishes.
But it’s an optional payment – you can either make the balloon payment and keep the car, swap the car for another model on another finance deal, or just return the car.
PCP finance is spread across an initial deposit, a series of monthly payments (including interest) and the optional final payment – the balloon payment – that you need to pay if you want to own the car outright at the end of the arrangement.
If you borrowed £30,000 with a PCP finance deal and the balloon payment was set at 25%, you would have to pay a final lump sum ‘balloon’ payment of £7,500 at the end of the agreement to keep the car. You pay off the £22,500, plus interest, via the deposit and the monthly payments.
Here’s a simplified example:
You choose to finance a car via PCP with a £30,000 purchase price
You agree a 36-month contract* and £10,000 deposit
The projected value of the car after 36 months is £7,500
*For simplicity we haven’t included interest in this illustration
The balloon payment is sometimes known as the guaranteed minimum future value (GMFV), or the optional final payment. Either way, a balloon payment is a set amount that is calculated before the PCP arrangement begins, based upon the car’s predicted depreciation. In other words, it is the value that the car is projected to retain over the course of the finance arrangement that has not already been paid off.
Because the balloon payment is a lump sum due at the end, it can help secure lower monthly payments over the term of the loan. This is because you are only paying off the depreciation (the predicted loss in value) of the vehicle over the term of the agreement – usually between two and five years. At the end of the agreement, you can either:
Choose to pay the balloon payment, at which point the car becomes yours
Hand the car back with nothing left to pay (providing all T&Cs have been met)
Swap the car for another on a new finance deal, or sometimes begin a new finance deal on the same car
The big advantage of a balloon payment is that it keeps your monthly repayments relatively low in comparison with other car finance options, whether you choose to pay it at the end or not.
It is also a fixed amount, calculated before you take out the loan, meaning that it won’t go up or down. This means you will know exactly what it will cost to assume ownership of the car.
A balloon payment can also offer flexibility: you don’t have to pay it if you choose not to buy the car, for example if you feel it has depreciated more than it should. You don’t have to decide until the payment is due.
If you don’t want to own the car, you can hand it back at the end of the loan term with nothing left to pay, providing it is in good condition and within the pre-arranged mileage allowance.
The balloon payment has a huge impact on your monthly repayments and is a central part of every PCP agreement. The bigger it is, the smaller your monthly repayments, though of course you’ll have to pay more at the end should you wish to purchase the car.
It’s important to understand how balloon payments work to ensure you’ve enough cash put aside to make the payment, or if you choose to swap the car for another, how much to put down as a deposit on a new car finance deal.
If you think you’d like to own the vehicle at the end of the PCP agreement, then think carefully about whether you can afford the balloon payment. If the answer’s no, you might be better off with another type of car finance, such as hire purchase or a car loan, which spreads the entire cost of the car across the duration of the loan term.
Although PCP monthly repayments are often smaller when compared with HP, you may end up paying more interest overall.
It’s worth remembering too that the more desirable the used car, the higher the balloon payment is likely to be. The less desirable the car, the lower the final payment.
Read more about car finance and find out which is the right option for you.