What’s a Residual Payment? A Comprehensive Guide

A residual payment, also known as a balloon payment, is a final lump sum payment required at the end of a loan term to fully own an asset. This payment typically represents the depreciated value of the asset. Opting for a residual payment can significantly reduce your monthly payments, allowing you to improve cash flow for other needs. But what exactly is a residual payment and how does it work? This comprehensive guide will explain everything you need to know.

What is a Residual Payment?

A residual payment refers to a large, predetermined amount that is due at the end of a loan or lease term. It is also known as a balloon payment. This payment is calculated based on the expected depreciated value of the asset being financed at the end of the term

For example, if you take out a 5-year car loan with a $10,000 residual payment, you would make regular monthly payments over the life of the loan, and then owe a final $10,000 payment at the end of the 5 years to own the car free and clear.

The residual payment amount is set at the beginning of the loan or lease, hence the term “predetermined.” It provides a pathway to full ownership by deferring a portion of the asset’s value to the end of the term.

How Does a Residual Payment Work?

Including a residual payment in your loan or lease lowers your regular monthly payment amount. Here’s a simple example to illustrate how it works

• You purchase a car for $30,000
• The loan term is 5 years (60 months)
• The residual payment is set at $10,000

Without the residual, your monthly loan payment would be around $525

With the $10,000 residual, your monthly payment decreases to about $416.

You make 60 monthly payments of $416 over the loan term. At the end of the 5 years, you owe the $10,000 residual payment to fully own the vehicle.

The residual payment defers a portion of the car’s original value to the end of the loan. This improves cash flow during the loan term, while providing a clear path to full ownership later.

Benefits of Residual Payments

There are several potential benefits to choosing a residual payment option:

• Lower Monthly Payments – Spreading out the cost over a longer period means smaller installments each month. This can improve cash flow for other business needs.

• Increased Buying Power – Opting for a residual can allow you to purchase a higher-valued asset that may have been unaffordable otherwise.

• Flexibility – At the end of the term, you have options to trade in, refinance, or pay the residual amount to own the asset.

• Tax Advantages – Monthly payments are generally 100% tax deductible as business expenses (consult your accountant).

Types of Assets Financed with Residuals

Residual payments are commonly used to finance large assets, especially for businesses. Some examples include:

• Vehicles – Cars, trucks, fleet vehicles
• Equipment – Manufacturing equipment, medical equipment, heavy machinery
• Technology – Computers, servers, printers, other IT infrastructure
• Real Estate – Commercial property, office spaces

For individuals, residual payments are most commonly associated with auto loans and leases. However, they can also apply to boats, RVs, and other large personal assets.

Residual Payment vs. Balloon Payment

Many people use the terms “residual payment” and “balloon payment” interchangeably. Generally speaking, they refer to the same thing – a large payment due at the end of a loan term.

However, there can be some minor differences:

• A residual payment is more commonly associated with leases, while a balloon payment is associated with loans.

• The residual amount may be based on the asset’s expected value, while a balloon is simply the remaining balance.

• Residually may offer more flexibility at end of term compared to a balloon.

But in everyday usage, the two terms are often used synonymously. The main point is they both refer to a large, final payment at loan maturity.

Things to Consider Before Choosing a Residual

While residual payments come with benefits, they also carry risks. It is important to weigh several factors beforehand:

• The Asset’s Value – Will it depreciate faster than the residual amount? If so, you may owe more than it’s worth.

• Your Future Financial Situation – Will you be able to afford a large payment in the future?

• Your Plans for the Asset – Do you intend to keep it or return/sell it?

• Refinancing Options – Will lenders allow you to refinance the residual amount?

• Disposition Costs – For leased assets, what are the turn-in or disposal fees?

Carefully projecting the asset’s value and your own financials can help minimize surprises when the residual payment comes due.

Residual Payments: A Useful Financial Tool

When used properly, residual payments can be an effective way for businesses to acquire assets and improve cash flow. By deferring a portion of the asset’s cost to the end of the loan or lease, monthly payments are reduced.

However, it is critical to accurately estimate the residual amount and prepare for this large payment down the road. Consult with your financial advisor to determine if residual payments align with your business goals and financial capabilities. With the right planning, they can be a smart financial move.