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When it comes to financing a car, two terms that often come up are “residual value” and “balloon payment”, but what exactly do they mean? Understanding what they are can go a long way towards helping you work out how they impact your car loan and whether they’re right for you.
Whether you're considering buying a new car or exploring your financing options, you can learn all about what residual value is and how to calculate it right here with Savvy today!
What is a residual value and how does it work?
The residual value of a car refers to the estimated value of the vehicle at the end of a car lease term. Essentially, it's the predicted worth of the car once the lease period expires and you return the vehicle to the leasing company or are given the option to buy it outright.
Calculating the residual value allows the lessor to charge the lessee an amount which reflects the declining value of their vehicle, rather than basing the ongoing payments purely on the value of the car at the beginning of the leasing agreement.
Is there a difference between residual values and balloon payments?
Yes – although the two concepts are similar, a balloon payment refers to the lump sum payment due at the end of a car lease or loan term. When it comes to leases, balloon payments are only relevant if you decide to purchase your vehicle.
It’s also important to understand how balloon payments work on car loans. Unlike traditional loans where the borrower repays the entire loan amount down to $0 in regular instalments over the loan term, a balloon payment allows the borrower to make smaller monthly payments across the term and settle the remaining balance in one large payment at the end.
Borrowers who opt for a residual value to be paid at the end of their car loan may benefit from lower monthly payments during the loan term, making it more manageable throughout the agreement. However, they must be prepared to make the lump sum payment at the end of the term to fully repay the loan.
Additionally, a loan with a balloon payment will cost more than the same loan without one. This is because car loans without a balloon will reduce to $0, while those with a balloon will only reduce to your car’s residual value (such as $10,000), resulting in more interest being paid across your instalments.
For example, a $30,000 car loan repaid monthly over five years at 7.5% p.a. would cost $6,068 in interest overall. However, adding a 15% balloon payment of $4,500 would increase the total interest to $6,846.
How is the residual value of my car calculated?
The minimum required residual value for car leases is determined by the Australian Taxation Office (ATO) and is as follows:
| Lease term | Residual value |
|---|---|
|
12 months |
65.63% |
|
24 months |
56.25% |
|
36 months |
46.88% |
|
48 months |
37.5% |
|
60 months |
28.13% |
It’s important to note that these only represent the minimum requirements, meaning your leasing company may require you to pay more if you wish to purchase your vehicle. Beyond the minimum amounts listed above, residual value is determined by various factors, including the car's make and model, its depreciation rate, market demand, and the length of the lease term.
However, when it comes to car loans, you can often customise the balloon payment to your liking. Balloon payments are common with car dealerships, although they may not always present the best value for you as a borrower.
How do residual values work with novated leases?
Residual values work the same way on novated leases as they do on other leasing arrangements. However, unlike traditional car leases where the leasing company retains ownership of the vehicle, in a novated lease, the employee leases the car through their employer and the lease payments are deducted from their pre-tax salary.
At the end of the novated lease term, you have several options regarding the residual value:
- Purchase the vehicle: you’ll have the option to purchase the vehicle outright by paying the residual value. This allows you to take ownership of the car and continue using it beyond the lease term.
- Upgrade your leased vehicle: you can also renew your lease with a different vehicle instead of purchasing your current one. Under this arrangement, your residual would form part of the new lease.
- Trade in your vehicle: alternatively, you may have the option to trade in the vehicle and cover the residual with the amount you receive from your dealership.
- Extend your current lease: if you’re happy with your current lease or are unable to pay the residual value in full, you may wish to refinance the residual value and continue leasing your car.
The pros and cons of residual payments on car loans
Pros:
- Lower monthly payments: this is the most significant advantage. By deferring a portion of the loan amount to the end, your regular monthly payments are lower, potentially freeing up cash for other expenses or investments.
- Easier on your budget: it may be easier to qualify for a car loan with a balloon payment due to the lower monthly repayments. This can be helpful if you have a limited budget initially but anticipate having a larger sum available by the end of the loan term.
- End-of-loan flexibility: by the end of your loan, you can clear your balloon by paying it outright, selling or trading in your car or refinancing it to extend your term.
Cons:
- Higher overall cost: as mentioned above, adding a balloon to your car loan can increase the amount you pay in interest by hundreds or even thousands of dollars.
- Large final payment: you'll be responsible for a significant lump sum payment at the end of the loan term. This can be a burden if you haven't planned and saved accordingly or if your financial situation changes.
- Potential negative equity: if the car's value depreciates faster than the loan amount, you may owe more than the car is worth at the end of the loan term. This could mean you end up having to cover the shortfall if the amount you receive from selling it or trading it in is less than the balloon.
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Bill TsouvalasFact checked
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