- A lump sum payment in the form of a lump sum payable at the end of your loan term.
- On a car finance deal, this can potentially cost you a lot of money and destroy wealth in the long run.
- If you already have a loan with a lump sum payment, there is effective ways to deal with it.
Balloons normally conjure up images of birthday parties, happy times and harmless fun. A lump sum payment on a vehicle finance deal, on the other hand, can potentially cost you a lot of money and destroy long-term wealth.
It is extremely important to understand what a lump sum payment is, how it works, and the potential impact of a lump sum payment on your car loan.
The purpose of a lump sum payment is to make monthly car loan payments more affordable for you. You can think of a lump sum payment as a lump sum payable at the end of your loan term.
With and without balloons
To illustrate this with an example, suppose two friends – Sam and Sam’s Bestie – buy the same car – costing them R400,000 each.
Both Sam and Sam’s Bestie take out vehicle finance, but Sam’s Bestie opts for a lump sum payment of 20% (or R80,000) of the vehicle price.
Source: Smart About Money
Sam’s monthly repayments over the five-year period will be R8,500, while Sam’s Bestie only pays R7,500.
Sam’s best friend feels rather happy to have an extra R1000 to spend every month. At the end of the five-year term, however, Sam will owe nothing on the car, while Sam’s Bestie will still owe the R80,000 lump sum payment.
By the end of the term, Sam’s Bestie will have paid around R18,000 more for the exact same car as Sam – see table.
There is more to consider when it comes to a lump sum payment. Suppose Sam’s Bestie does not have R80,000 to settle his lump sum payment at the end of the five-year period.
Sam’s Bestie’s bank graciously offers to extend his loan for three years. It will cost R2,700 a month though, meaning Sam’s Bestie paid almost R625,000 for a car that cost R400,000 eight years ago.
The real punch for Sam’s Bestie, however, comes when the loan is paid off and the car can be sold.
After eight years of depreciation, Sam’s Bestie’s car is now worth just R170,000 – effectively meaning a loss of R455,000 over the eight-year period.
Sam’s car will also depreciate, but he will have a car paid off much sooner than Sam’s best friend.
How to pop the balloon
There is hope, however, for Sam’s Bestie and people who find themselves in a similar situation.
If you currently have a lump sum payment, the most effective ways to pop the balloon are to follow one of the following tactics:
- Use any excess funds you may have to settle your debts faster.
- Open a savings account to save for the lump sum payment due date.
If you are looking for a new vehicle, avoid lump sum payments as much as possible.
It is also a good idea to try to save for a healthy deposit.
It is crucial to only buy what you can afford. Generally, a vehicle is a depreciating asset. This basically means that you are borrowing money to finance something that goes down in value as soon as you take it off the showroom.
If you want to better understand car financing and lump sum payments, talk to a financial adviser – ideally a certified financial planner – who can explain the different options available to you in a simple and clear way.