The balloons you get when you buy a car on residual...

Thought Thursday: Balloon payment, what does it mean?

So you’re at that point in your life where you need to buy a new car. It’s either your first ever car or it’s time to ditch that old hand me down that your parents gave you when you got your license. Either way, you’re excited and ready for your friends and peers to take you seriously in some sweet new wheels. You’ve planned your budget, you’ve decided what you’re going to get and then when you get to the dealership, the sales person throws a spanner in the works. “You can get your dream car for only R4000 pm” he says. You ask him how that’s possible and he tells you to finance the car with a residual, also known as a balloon payment. You ask him to explain further but all you hear is “blah blah blah you can get your dream car for only R4000”.

So today we want to explain in simple language, what a residual is. A residual payment contract is when the people you’re financing with take a certain percentage of the total amount you’re borrowing and reserve it, to be paid as a lump sum at the end of the finance period, when your last instalment is due. For instance, if the car you’re buying is R100 000 and you do a 10% residual, you will pay your monthly instalment based on R90 000. Then at the end of the loan period you will pay the 10% that was calculated as the residual amount as a lump sum, which is R10 000 in this case. The main reason why this seems so appealing is that you can pay less for a more expensive car. The problem is that it is way more complicated than a cheaper instalment and lump sum in the end.

People and cars are interesting things. People like to change their cars often so chances are you won’t be keeping the car you’re buying for good. Chances are that you will want to trade it in before you’re finished paying it off. This is where timing and mileage comes in. Cars depreciate quicker than finance arrangements stay in place. The general rule of thumb is that if you buy a car today, you will be able to trade it in comfortably in the next three years of paying it off monthly, but that depends on the type of car you buy and the mileage you’ve travelled when you trade it in. The problem with a residual is that it can further delay that trade in time because you will have to include the residual amount on top of what the dealership offers you as a trade in value. At times, you may find yourself with a shortfall when you want to trade in your car with a residual. This is the difference between what your car is worth and the amount outstanding on your finance contract.

The only time a residual may work in your favour, is if you are able to keep your mileage low because a dealership will be able to trade in your car at a higher price and cover the residual amount as well. If you have done many kilometres in your car, your car would have depreciated greatly and that will cause the dealership to give you less, increasing the chances of a shortfall. If you are someone who wants to keep their car for good, a residual is not for you. It honestly doesn’t make sense to pay a certain amount every month and then a large lump sum at the end as well. A residual is beneficial only if you are able to trade in your car at the right time with the right mileage. So as you can see, there are pros and cons to this type of finance arrangement and to simplify it, there are as follows:

Pros:

• A residual lowers your monthly instalment, allowing you to buy a car of higher value but pay less for it monthly.

• A residual can come in very handy if you want to buy a more expensive car BUT you don’t do a lot of mileage and you want to trade it in after three years or so.

Cons: 

• A residual means that at the end of the finance period, you will have to pay a lump sum of cash if you are planning on keeping the car.

• Depending on the timing and the mileage, a residual can create a shortfall amount if you want to trade in your car before you’ve paid it off.

So, next time you’re offered a residual, think about this article. Of course there are other options when it comes to a residual. For instance you can refinance the residual amount if you don’t have the cash to pay the lump sum at the end of the period. If that’s the case, you may as well buy your car a ring and give it your surname too. Happy Thought Thursday Motorists.

*Image courtesy of http://www.safelybrake.com