Before you sign your loan papers and take your new car home, it's important to understand the dangers of a balloon payment car loan.
What is a Balloon Car Loan?
Balloon auto loans are structured to reduce monthly payments by shifting a significant portion of your loan to one final payment. So you might cut each payment by $100 and add a final installment of $5,000 at the end of the loan's term. Since lenders front-load interest, when your balloon payment comes due you are usually paying off the principal of the loan.
So what are the dangers?
Keep Your Payments Low
A balloon loan is a good option if you need to keep your monthly payments low and know you'll have the money to pay it off towards the end of the term. Additionally, balloon loans are an option for those people who absolutely need a new car but have no money for a down payment.
Plan in Advance
It's important to plan for your balloon payment in advance. Save monthly, or invest with this in mind. You should also know that refinancing a balloon loan can be difficult. It may be possible to extend the length of your balloon loan at the end of the term, but that isn't guaranteed. And if you do refinance, you might end up stretching your original three-to-five year term to seven years, or even longer.
Not having the money for your balloon payment at the end of the loan is really the worst-case scenario for the lender -- and for you. If you miss your payment, cannot make arrangements, or cannot refinance, you may lose the car even after you've paid the interest for all those years.
If you have the option to buy the car back, you still have to come up with the principal to do so. Under a normal loan, if you lost your car towards the end of the term you could buy it back for far less than you could with a balloon loan.
Dangers of a Balloon Car Loan
There are many concerns you should have about taking out a balloon payment car loan:
- The first concern should be obvious, but many dismiss or overlook it. It is highly unlikely that you will be in a better financial position in three to five years, as much as you hope or would like to think that you will be.
- You need to carefully consider what you will do if you are unable to refinance your car at a better rate and with better terms. How will you pay that loan off? You will still be obligated for the balloon payment. Are you prepared to let the car go? What will you do for transportation? Not making that balloon payment will damage your credit score.
- Another concern is that since you are paying only interest on the loan through the end of the loan period, you will likely owe more on the vehicle that it is worth. This will cause you great difficulty in selling for the amount you owe or refinancing the loan.
- Before taking on a balloon loan for a car purchase, carefully consider the value of the car, the expected value in two or three years when the balloon car payment will be due, and how much you are willing to sacrifice to own the vehicle. In many cases, a balloon loan is not the right financing option, and simply allows you to incur more debt that you can really afford.
Benefits of a Balloon Car Loan
Here are some of the benefits of getting a Balloon Car Loan:
- A balloon payment car loan buys time: The lower payments during the loan term allow for the borrower to collect the cash due to pay off the entire debt. Some scenarios include other investments that may mature during the loan term, or changes in income that will allow the borrower to pay off the entire debt.
- A balloon payment car loan allows for a "sale option": If the borrower holds the title in the interim, he or she has the option of selling off the vehicle and using the resulting cash to pay off the loan. It's important to talk about this situation when taking out a balloon payment car loan, as liens or other types of restrictions may prevent or delay resale.
- A balloon payment car loan is essentially "lump credit": The lender carries much more of the deficit throughout the term of the auto loan, leaving more cash in the hands of the borrower.
- A balloon payment car loan generally offers a lower chance of repossession: Because of the fact that the loan payments are smaller than they would be with a different type of loan, there is a lower chance that repossession agents will show up at the door looking to take a vehicle.
Requirements for a Balloon Car Loan
There are two main requirements for getting a balloon car loan:
- In order to qualify for a balloon loan, you need to have a regular income -- in other words, have proof that you are employed and can make payments on the car.
- You need to have a solid credit rating, although the exact number is flexible with some lenders.
How to Compare Balloon Car Loans
It is important to take the time to compare a balloon car loan against different loans. You do this to make sure you are getting the best deal possible. Taking the time to compare these types of car loans is very important, but knowing how to compare the balloon payment car loans is also important.
1. Understand the End Number
Every balloon payment car loan has a final number -- this is the amount you will be making on your final payment. You should understand what that number is going to be, so ask.
2. Check out the Monthly Payment
Knowing you can afford the payment is also something you should know. During the course of the loan, the amount you pay each month could rise, making later payments much larger than when they started. Check this out by calculating the interest rate, and the total cost of what you are paying off.
3. Compare the Interest Rates
Knowing which interest rates you are going to be paying is crucial to your bottom line cost. Compare rates and compare the rates of how the loans will increase, or decrease over time. Check each lender and ask for a detailed amortization (or amount of projected time it would take to pay off the debt) of the loan. This will show you exactly where you will stand each month.
- First, you can have a low interest rate which will make for a low initial payment that will rise over time for a higher ending payment.
- Second, you can do the opposite. You can start with a higher interest rate which gives you a larger initial payment, but decreases over time.
- See what kind of interest rates you can get >>
Balloon loans can be extremely beneficial to the right customer, but you should be aware of the dangers. More so than any other loan, you need to have a plan to take care of the balloon payment ahead of time. With careful planning and proper research you may be able to avoid any drawbacks.
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