A balloon is not a discount

You are buying a machine or a vehicle, and the quote comes back with two numbers: a rate, and a monthly payment that is lower than you expected. Somewhere in the fine print is a residual, or a balloon, and nobody spends much time on it because the payment is the thing you asked about.

The payment genuinely is lower. That is not a sales trick and there is nothing dishonest about it. But the reason it is lower is that you are not repaying all of the debt, and the part you are not repaying is still there at the end, earning interest for the financier the entire time.

What is actually happening

A normal facility amortises to zero: every payment chips away at the balance until there is nothing left. A balloon facility amortises down to a number instead. Set the balloon at 25% and you are only repaying three quarters of the debt across the term, so the payment falls by roughly a quarter, less the interest you are still paying on the untouched part.

At the end of the term the balloon falls due in one payment. You pay it, refinance it at whatever rate is available on the day, or sell the asset and hope it covers.

The trade, in figures

Take $550,000 of plant over five years at 8.5%, with a 25% balloon. Here is the same facility with and without it.

Both of those are true at the same time, and only one of them is ever on the quote. The monthly saving is what gets sold. The extra total cost, and the fact that a six-figure sum falls due in a single month against a five-year-old machine, are left for you to work out.

The question is not whether the payment is lower. It is whether the asset will be worth the balloon when the balloon falls due, and whether you would rather have the cash now than later. Those are real business questions with real answers. They are just different questions from the one the quote answers.

When a balloon is the right call

• The asset holds its value well. Some plant and many commercial vehicles are worth a good deal more than their residual at the end of a five-year term, and in that case the balloon is close to free optionality.
• Cash flow now is genuinely worth more to you than cash flow later. A business funding growth, or working through a tight patch it can see the end of, is right to value the money today.
• You expect to replace the asset at the end anyway. If the plan was always to trade it in and start again, the balloon and the trade-in tend to cancel out.
• It is an operating lease, where the financier carries the risk on what the asset is worth rather than you. That is a materially different product from a chattel mortgage with a balloon, even though they can look similar on a payment schedule.

When it bites

The uncomfortable case is a fast-depreciating asset on a long term with a heavy residual. You can reach the end owing more than the thing is worth, which means selling it does not clear the debt and you are refinancing a shortfall on an asset nobody wants to lend against.

It also bites when the plan changes. A balloon assumes you will be in a position to deal with it in five years. Businesses that are tight now and set a large residual to make the payment work are betting on being in better shape later, and that bet is not always a good one.

The other number nobody mentions

While you are comparing quotes, check whether each one is struck in advance or in arrears. Paying at the start of each month rather than the end makes every payment a month earlier, so the figure falls by exactly one period of interest.

On the facility above that is about $66 a month. Not enormous, but it is a difference with no substance behind it, and it is the single most common reason two quotes on identical terms do not match. If one financier quotes in advance and another in arrears, you are not comparing like with like until you convert.

What to ask

• What is the total I will pay across the term, including the balloon? Not the payment. The total.
• Is this quoted in advance or in arrears?
• What happens at the end if I want to keep the asset, and what if I do not?
• What is the payout figure if I want out in year three, and how is it calculated?

None of those are awkward questions and any decent financier will answer them. The reason to ask is not suspicion. It is that a balloon is a genuine trade with two sides, and you can only make the trade deliberately if you can see both.