When drafting loan agreements, there are a number of different ways these loans can be structured. Whether financing a personal car, or leasing assets for your business, you will likely encounter a balloon payment at some stage in your life. A balloon payment is an amount payable at the end of the loan period. Essentially, it is a loan where you pay reduced monthly instalments for the term of the loan. Then you pay a large final payment (balloon payment) that clears the debt.
For example, when you lease a car, you pay the monthly instalments. When you trade it in, the trade value equates to the balloon payment you ought to pay. This balloon structure can apply to a variety of different assets. Every situation is different, and contractual financing can be complicated at times. Accordingly, it is always good to know how best to approach these situations, and where it is best to either embrace balloon payments or avoid them. We have listed some points for your consideration below.
When to Include A Balloon Payment
Whilst each situation can vary on a case by case basis, balloon payments are generally best suited to the following instances:
More tax deductible interest
Only the interest component of a business related asset is tax deductible. If the main part of the regular repayments are interest and the balloon repayment is the cost of the asset, it is likely more of your outgoings can be claimed on tax. Familiarising yourself with any business tax concessions is always beneficial.
Lower ongoing repayments
Given the lump sum payment at the end of the loan the actual amount financed is lower hence lower repayments. A balloon repayment reserves cash-flow for the life of the loan. Therefore, the loan is generally more affordable over its term.
Increased affordability
The new asset may allow a business to earn additional income. This will pay the balloon repayment at the end of the loan. This is good at times when money is scarce, but future prospects of a business are promising, like if you are just starting a business.
When To Avoid Balloon Payments
Whilst there are some clear benefits to loans structured with balloon payments, they are not always suitable. The following instances are times when it may be best to avoid such a loan structure:
Higher interest
When making lower repayments during the life of a loan, you will likely pay more in interest with a balloon loan. If you can maintain higher regular loan repayments than a loan without a balloon payment, then this option may save on interest.
When an asset is worth less than the balloon
Your asset may depreciate faster than average for various reasons. You may find that your balloon payment is therefore more than the value of your asset. This means you will have to find the difference if you decide to trade-in or sell the asset, and may not be in your interests.
Conclusion
Evidently, there are a number of factors you must take into account when engaging in contractual loan agreements. It is important that you are aware of all the legal and financial effects of these. The NSW Government Fair Trading website contains more information on this. If you are unsure about your loan agreement, it is always a good idea to consult with a contract lawyer.
