One of the most popular car finance products on the market is Personal Contract Purchase. A big reason behind its popularity is because you don’t pay for the entire cost of the car during the package, and the flexibility you have at the end of the agreement, where you have three different options.

The first option is to finish the finance agreement and return the car to the dealer. The second option is to pay the balloon payment and own the car. And the third option is to part exchange the car you’ve been financing and use it towards a new car finance product.

To those unfamiliar with Personal Contract Purchase, the balloon payment can be a bit mystifying. So here’s a quick explainer.

What is a balloon payment?

The balloon payment is the term used to describe how much you would have to pay to buy the car at the end of a personal contract purchase agreement. In a personal contract purchase agreement, you don’t pay off the entire cost of the car. Instead you pay off the depreciation in the car’s value from the start of the agreement to the end of the agreement.

This depreciation is calculated at the start of the agreement and then this is set as the cost of the package across the term length.

How is the balloon payment calculated?

The balloon payment is calculated using a car’s guaranteed future value. The depreciation of every car can be calculated, normally by seeing how similar makes, models and types of car perform on the used car market. This guaranteed future value will not change, no matter what happens in the economy or used car market during the length of the car finance agreement, hence the ‘guaranteed’ future value. That means you could end up paying less or more than the loss in value across the agreement.

What is the benefit of a balloon payment?

The biggest benefit of the balloon payment is that it reduces the cost of the finance agreement. Instead of paying for the total cost of the car, you pay for the car’s loss of value across the term length. That might mean newer or better cars are now an option for you, vehicles whose sale price is far too high for your budget.

You can also benefit by choosing cars that don’t suffer as much from depreciation. There are websites online where you can search for the models that preserve their value the best.

Should I pay the balloon payment?

The balloon payment is there for you at the start of the agreement, so if you really want to own the car you’re financing, you have a target to work towards. If you know your financial circumstances are going to change in the future, such as changing your job, then you might be in a better position to pay this lump sum than you are when you take the finance product out.

But, if you don’t want to own the car or want to try a different finance package, then the other two options available on a personal contract purchase mean you don’t have to pay the balloon payment.