South Africans buying cars face a debt trap

Many South Africans are using balloon payments to afford cars, but without understanding the long-term risks, they risk falling into a costly debt trap when the large final repayment comes due.

As South Africans contend with high living costs, car financing options that reduce monthly payments are becoming increasingly popular.

This includes balloon payments, a type of car loan where consumers have lower monthly instalments if they agree to pay a large lump sum at the end of their loan term.

Recently, Standard Bank said that a third of its customers have included the maximum balloon payment over the last year.

“Given the current cost of living crisis and the 15-year high interest rates in South Africa, consumers are looking for more ways to stretch their budgets,” said the Head of Standard Bank VAF Enablement, Glenn Stead.

“High fuel costs have added to consumer strain by pushing up vehicle ownership costs significantly in the past three years.”

Ernest North, co-founder of insurance platform Naked, echoed this sentiment, saying that balloon payments have become increasingly popular in South Africa due to rising living costs, including the higher costs of car purchases and ownership.

While this can be a useful tool to reduce monthly repayments, many consumers choose a balloon payment without understanding that they could end up in a debt trap four or five years down the line.

“Lowering your monthly repayments can help you to stretch your salary a bit further and potentially afford a better car,” North said.

“But the lump sum at the end of the loan term is the sting in the tail. While a balloon payment can be a useful financial planning tool, all too many people find that they struggle to afford the final repayment.”

The real costs of balloon repayments

Usually, a balloon repayment is between 20% and 35% of the vehicle’s value, with 40% being the maximum most banks would allow.

During the repayment term, consumers pay lower monthly instalments. This is because they’re not paying off the full loan – just a portion.

This might feel like a win, but North urged South Africans to consider the total costs of buying a car. The table below shows the full cost of purchasing a R500,000 car on a six-year loan, assuming no deposit and an interest rate of 10.5%.

	Monthly repayment	Lump sum at end (balloon payment)	Total cost of credit
No balloon	R9,481	R0	R682,000
With a 20% balloon payment	R8,478	R100,000	R710,000
With a 40% balloon payment	R7,475	R200,000	R738,000

When the balloon payment is due, a buyer has the following options:

• Pay it off in cash and own the car outright.
• Refinance the outstanding balloon payment. They’ll enter a new loan agreement and face another few years of making monthly payments and interest charges. To take this option, they will need to qualify for financing.
• Extend the loan term. Some lenders might allow you to stretch out your repayment period further, though this could mean paying even more interest costs. This is only possible for creditworthy buyers.
• Sell or trade in the car, leaving you without an asset after forking out cash for months. Even then, they will still need to settle the balloon payment.

North added that these numbers and options clearly outline the significant risks and costs of balloon payments. He noted that while the monthly savings may seem attractive, they are minimal compared to the long-term financial dangers.

At the end of the loan term, the buyer will either need to have the cash available to settle the balloon payment or take on additional financing.

The larger the balloon payment, the more interest is paid over the life of the loan, and due to depreciation, the vehicle may be worth less than the final payment owed.

This can trap consumers in a cycle of refinancing every five or six years, preventing them from ever owning a car outright. Exiting the loan early can result in settlement penalties in addition to the outstanding balloon amount.

In more severe cases, if the car is stolen or written off, the borrower may be forced into early settlement and face a substantial shortfall. If they cannot afford the final payment, they risk repossession under the National Credit Act.

“In theory, a balloon payment gives you the option to pay a large cash amount at the end of your finance term, and then you can keep the car,” North said.

However, most people don’t have that kind of cash lying around, so they end up having to sell the car. “And if the car’s value is less than the outstanding balloon amount, it becomes a very serious problem – one that many people are unfortunately facing.”

Balloon payment offers opportunities

Despite the costs and risks, North said that there are some instances where balloon payments can be a helpful tool in your financial planning.

For example, they may suit individuals who regularly trade in their vehicles for newer models and are confident in their ability to settle the balloon payment when it becomes due.

They can also work for those who reasonably expect their income and savings to grow over the loan period, or for buyers who prefer a new car’s reliability and warranty coverage over the uncertain maintenance costs of an older model.

Additionally, balloon payments can benefit business owners who can claim tax deductions on depreciation, interest, fuel, maintenance, and possibly the balloon payment itself, improving cash flow.

Finally, they may be appropriate for borrowers who do not foresee needing to exit the loan early and intend to keep the vehicle for the full term.

For buyers who are still considering a balloon payment, North said that a Guaranteed Future Value (GFV) finance option could be a safer alternative.

GFV agreements add a layer of financial security by guaranteeing the car’s value at the end of the finance term, regardless of how much it has depreciated.

This guaranteed amount functions as your balloon payment, also known as the “optional final payment”, and is agreed upon upfront.

When the finance term ends, the customer has three choices: make the final payment and keep the car, trade it in for a new car, or give it back with nothing more to pay, even if its actual market value is lower than the GFV.

As such, it offers peace of mind and avoids the burden of being left with a car worth less than the lump sum you still owe.

North warned consumers against using balloon payments to buy a car you can’t actually afford in the long term.

“Rather, put down a larger deposit or choose a more affordable car. Remember, a more expensive car will also have higher maintenance and insurance costs,” he said.

“While it can make sense in some circumstances, the downside of a balloon payment is very seldom worth the benefit.”