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Beware the Balloon Loan for Used Car Financing

It’s Good for the Lender and Rarely Good for the Consumer

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Beware the Balloon Loan for Used Car Financing

Beware lenders who want to get you into a used car with a balloon loan.

Photo © Getty Images

There's a disturbing new trend in the used car financing business called balloon loans that are good for the lender and not that great for the used car buyer.

Ok, so technically balloon loans aren't new in the industry. It's more accurate to say they are undergoing a resurgence as the economy improves and credit unions want to improve their bottom lines.

Joshua Kennon, who is the guide to new investors at About.com, has a good explanation of what balloon loans are. They are actually technically called partially amortized loans. As Kennon explains in a good example, " If John took out a mortgage for $100,000, and $90,000 was amortized over a period of 30 years, the remaining $10,000 would be due immediately, in one lump sum, at the end of those 30 years."

Substitute $30,000 for a used car balloon loan, with $25,000 amortized over a period of five years, with the remaining $5000 due in one lump sum at the end of five years, and you understand how a used car balloon note works.

Why are these loans bad for consumers? Well, initially it allows them to purchase more used car than they can afford with lower monthly payments and less down payment required at signing. Then the loan comes due and all of the sudden they don't have the $3000 to pay off.

That's a big problem because you don't hold title to the used car. Thus, you are at the mercy of the lender, who might extend you a short-term loan to pay the remainder due at what is bound not to be the greatest interest rates. Conversely, you may not end up dealing with the lender and instead finance that payment on your through, perish the thought, an advance on your credit card.

As Michelle A. Samaad reports at Credit Union Times, " … used car loans continue to rev up a turbo boost for many credit unions. So much so that some are seeking nontraditional methods to keep the lending momentum going. Among them, leases and balloon loans, which advocates say can bring in higher yields than traditional financing and potentially offer more savings for members on their monthly payments."

Samaad also reports the case of one successful credit union that through "offering a lease-like loan, its members have been able to get cars they normally wouldn't be able to afford through an average savings of 30% to 40% on their monthly payments … For the credit union, the yields are 1.5% to 3% higher than traditional financing."

In addition to the profits, there is another reason the credit unions like these kind of loans. Apparently they engender consumer loyalty because most consumers will finance ongoing new or used car purchases through the balloon loans.

There was one telling observation from a lender in the Credit Union Times article. Consumers like the loans because they don't have to stretch out their used car loans for eight or nine years to afford the used car they want.

What does that tell you about consumers? They are still buying more used car than they can afford. One can't blame credit unions (banks make these loans too) because they are in business to make money. No, the fault has to lie with the consumer who buys too much used car.

There are ways to avoid a dependence on used car balloon loans:

  1. Don't shop based on monthly payments. Any used car seller can find financing based on monthly payments, which could stretch out for years to come.
  2. Got the urge to replace your current vehicle? Take a deep breath and wait at least six months. Set aside what you would have paid in loan payments in a separate bank account.
  3. Take the funds from that account and make that your down payment. In effect, make your balloon payment up front instead of at the end of your loan.
  4. That means at the end of your five-year loan, you actually own your used car outright and don't have to come up with the balloon payment.

    There are certain consumers who can benefit from a used car balloon loan: people with good fiscal habits. If you have the discipline to set aside, for example, an extra $100 a month - and not touch it - at the end of five years you're going to have $6000. In that case, you have been able to drive more car for a lower initial monthly payment and less money down.

    For the rest of us mortals, myself included, balloon payments just aren't going to make sense in the long run. You will probably find yourself in a bad fiscal position when the loan ends.

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