Balloon loans offer flexibility in payments, but does this come at the expense of long-term savings?

0

Dubai: If you’ve been looking for more flexibility and ease when repaying your loans in monthly installments, especially when it comes to making payments in the first few months, a ‘balloon loan’ is one of these choices. But how risky are they? Let’s find out more before choosing to use them.

A balloon loan is a type of loan that includes lower monthly payments in exchange for a larger one-time payment at the end of your loan term. It works just like a normal car loan, except there’s a larger mandatory “balloon” payment deferred until the end of the agreement.

Here is an example of a balloon loan

For example, if you have a mortgage with a lump sum payment, your payments may be lower in the years before the lump sum payment is due, but you may owe a significant amount when the loan ends.

Suppose a person takes out a mortgage of 200,000 Dh with a term of seven years and an interest rate of 4.5%. Their monthly payment for seven years is 1,013 Dh. At the end of the seven-year term, they owe a lump sum payment of Dhs 175,066.

When it comes to a balloon mortgage, the term is usually quite short, ranging from 5 years to 7 years, but the payment is based on a 30 year term.

What is one of the main advantages or risks of taking out such loans?

“Balloon loans often allow borrowers to access a low interest rate. But the cons often outweigh the positives, because there’s no guarantee the borrower will be able to refinance at that same lower rate — or will be able to refinance the loan at all,” Bryden said. Wood, a Dubai-based banking analyst.

“Lump-sum payments also have disadvantages that need to be taken into account: unsecured loans with lump-sum payments generally have a higher interest rate than conventional loans. Paying that big lump sum payment at the end of the loan can be financially difficult for your business,” Wood explained.

Is there a downside to taking out a balloon mortgage?

When it comes to a balloon mortgage, the term is usually quite short, ranging from 5 years to 7 years, but the payment is based on a 30 year term. They often have a lower interest rate and may be easier to qualify for than a traditional 30-year fixed rate mortgage. However, there is a risk to consider.

“If the value of your property declines, you lose your job or face other financial difficulties, you may not be able to sell or refinance before the lump sum payment is due. If you can’t make the payment, you risk losing your home to foreclosure,” Wood added.

Lump sum payments

Image Credit:

Is there a cap on the lump sum payments allowed?

“Although lump sum payments are about paying off a significant portion of your loan at the end, they are usually capped,” explained Rupesh Naish, a Dubai-based debt consultant.

“Generally, most lenders will cap lump sum payments at 50% of the total amount payable. So if you are looking to buy a Dh30,000 car, your lump sum payment could not be more than Dh15,000.

Is there another alternative to balloon loan?

There is another similar option that requires less commitment on your part than a lump sum payment – ​​a residual value loan. But what is the difference between residual value and lump sum payment?

Simply put, a residual value and a lump sum payment are the same. Both refer to a pre-agreed payment due at the end of a loan for a vehicle, machine or property. If the loan facility was a financial lease, the amount at the end of the lease is called a residual.

What is a residual value loan?

A residual value loan, which generally applies to car loans, applies the same principles as a lump sum payment but works a little differently. For example, the idea is that you lease a car for a fixed period and pay a lump sum at the end of the period if you want to own the car.

You will still pay a monthly amount during your rental period, just as you would for a lump sum payment; but you don’t commit to buying the car at the end. If you want, you can return the car to the auto finance provider or sign a new lease agreement and continue leasing it for another set period.

Car loan financing

When using residual value loans, buyers may get lower premiums on new cars, but used cars may have higher monthly premiums because their value generally depreciates more.

Are residual value loans better for new or used cars?

“When using residual value loans, buyers may get lower premiums on new cars, but used cars may have higher monthly premiums because their value generally depreciates more,” Naish added.

“The loan provider can monitor how many miles you drive in the new car and could penalize you for high mileage or lack of maintenance. This is because the mileage and condition of a car affect its resale value.

Bottom Line: Is a Lump Sum Payment a Good Idea?

For buyers who can save the amount needed, a lump sum payment can be advantageous, and for investors, it can free up short-term capital. In most cases, however, lump sum repayments are an easy way to get into debt.

Most people who earn an average income and cannot pay the initial repayment amount also cannot accumulate the amount needed to pay the lump sum at the end of their repayment period.

“It’s not always easy to think about the long-term ramifications of lump sum payments. Many people know how easy it is to go over budget when they have a specific car or property at heart, especially when a lump sum payment option seems so appealing,” said Andrea Barber, a financial planner based at Abu Dhabi.

“Unfortunately, people in this position often cannot pay the lump sum at the end of the funding period and debt problems ensue. To guard against this, finance companies often require proof that buyers will be able to afford a future lump sum payment.

Share.

Comments are closed.