What is a car balloon payment?

What is a car balloon payment?

The final payment of your PCP finance deal can mean low monthly instalments, but a big bill at the end of the contract.

If you finance a car on a Personal Contract Plan (PCP) deal, you’ll be faced with a balloon payment at the end of the contract. Also known as the optional final payment, it’s a key element of this type of car finance, and can have a major impact in reducing your monthly payments.

The bigger the balloon payment, the lower your monthly payments. Which is great during the length of the contract, but means you’ll be faced with a large bill at the end if you want to buy the car.

The balloon payment is agreed at the start of a PCP deal, and represents what the finance company thinks the car will be worth at the end of the deal. Unlike a hire purchase car finance agreement, where your monthly payments go towards the purchase price of the car, plus interest, a PCP deal sees your monthly payments cover the expected depreciation of the car. Then you have the option to buy it at the end using the balloon payment.

It’s important to understand the details of how balloon payments work – you don’t want to find yourself without enough cash at the end of the contract to be able to either buy the car or put down a deposit on a new one.

PCP balloon payment explained

A PCP finance agreement has three key elements. The deposit is paid at the start, and then you’ll have a set period of pre-agreed monthly payments. Then at the end of the contract – usually between two and five years – you have three choices. You can give the car back with nothing to pay; however, this leaves you with nothing for all the money you’ve spent thus far. Alternatively, you can trade the car in for another one.

The third option is to pay the final balloon payment to own the car. This is likely to be roughly what the car is worth – the amount is fixed at the start of the deal based on the estimated depreciation of the car. The balloon payment is also known as the guaranteed minimum future value (GMFV) of the car, and as the optional final payment.

Because you know the final amount from the very start of the contract, you’ll know the cost if you want to buy the car at the end. Think carefully about this – you can always refinance the balloon payment if you need to. But if you’re set on owning the car, you might want to consider hire purchase (HP) instead. The monthly payments will be higher, but you’ll likely pay less interest overall, and you won’t need to pay a balloon payment at the end.

How are PCP finance balloon payments calculated?

The optional final payment on a PCP finance contract is based on the value of the car at the end of the agreement. This is calculated using industry guides, but it’s never an exact science. More on that in a moment.

Once that value is settled on, it forms the balloon payment due at the end of the deal. Then the rest of the deal is worked out – the initial deposit and the monthly payments. These equal the difference between the price of the car when new and the final balloon payment. Interest is added, and the deposit taken off – you’ll get lower monthly payments and pay less interest overall if you pay a larger deposit.

That all means that the deposit and monthly payments aren’t going towards the price of the car, they’re paying for the value that the car is expected to lose over the course of the contract.

Cars that are highly sought after as used models will be worth more at the end of the deal. That means they’ll have higher balloon payments, but the monthly payments will likely be relatively low because of less depreciation. Less desirable cars will have lower balloon payments but could cost more per month.

At the end of a PCP contract you can give the vehicle back to the lender or make the balloon payment to settle the finance and buy the car. You can often refinance the balloon payment.

You may find that the actual worth of the car at the end of the deal is more than the balloon payment. This is called having equity – you can trade the car in for another model, and that surplus can go towards the new deposit.

If the car is worth less than the balloon payment, then you’re protected from the negative equity – simply hand the car back and the financial hit is on the lender, not you.

Should I aim to make the balloon payment?

If you’re entering a PCP deal with the aim of owning the car at the end then yes, you should be prepared to make the balloon payment, either outright or refinancing with a hire purchase (HP) contract.

Before you make any payment, however, get your car valued – you can do this online, at a dealer or another car buying group. If the value is less than your balloon payment, then you’ll be better off returning the car and buying a similar used model for less.

You should also note that if you do make the optional final payment, then you’ll be paying more interest than an equivalent HP finance deal. HP deals see you pay off the finance balance faster so the interest doesn’t stack up as much. But the downside is that the monthly payments can be considerably higher on HP as you’re paying for the purchase price of the car, rather than just the depreciation.