PenFed Reimagines Balloon Loans

Pentagon Federal Credit Union will begin offering members a balloon auto loan this summer that removes one of the biggest risks these loans pose for borrowers: Having their cars repossessed because they can’t afford the final payment.

Consumer advocacy groups are leery about current balloon payment auto loans, comparing them to the balloon mortgages that triggered many foreclosures during the housing bubble preceding the Great Recession.

The loans are designed to be appealing for consumers because they have significantly lower initial monthly payments – which consumers pay a lot of attention to – while they have a large, often unaffordable final payment down the road, something consumers tend to ignore or rationalize away.

On conventional balloon loans, if consumers can’t make that final payment, they can refinance, piling on more interest costs, or lose their car through repossession, damaging their credit record.

However, PenFed’s “Payment Saver Plus Program” removes the risk of credit damage, making a walk-away just another option to satisfy the balloon payment obligation.

“They don’t have to risk any negative credit reporting,” said Ivan McBride, vice president of auto lending product sales at PenFed, based in Tysons, Va. ($24.5 billion in assets, 1.7 million members).

McBride said PenFed is trying to work with its mission of serving members, while recognizing that many of its members manage for cash flow, making the size of the monthly payment their top concern when financing a car.

The loan program is facilitated by Auto Financial Group of Houston, Texas, which has been trying to encourage leasing among credit unions and other lenders by guaranteeing residual values and providing services designed to make leasing a nearly turnkey operation.

A balloon auto loan is similar to a lease in that the final payment is based on the residual value of the vehicle. The larger the residual, the lower the pre-balloon payments that can be offered.

However, betting how much a new Toyota Corolla or a Jeep Cherokee might be worth five years from now involves a level of sophistication beyond the scope of most credit unions.

That’s the space companies like AFG and Fusion Auto Finance, based near Fort Worth, Texas, have been working.

In PenFed’s balloon program, AFG will be guaranteeing the residual, contacting owners in the final year of their loan to determine their plans, and handling the remarketing of cars from walkaways.

PenFed will be among the first to offer these types of loans for both new and used cars up to five years old, Joe Leonard, PenFed’s vice president of indirect automotive sales development, said.

“It’s going to be an industry leader in that we’re willing to tackle the used car market also,” Leonard said.

Ivan McBride, PenFed’s vice president of auto lending product sales, said the credit union still is predominantly a direct lender for its members. It encourages members to study prices for the car they want and get pre-approved.

They should “not focus on the payment when they step onto a dealership,” he said. “I would first settle on a price with the dealership.”

The walk-away balloon loans are designed for members who are attracted to the features of leasing, but want to have ownership of the car without the huge end-term risk of not being able to meet a balloon payment.

“We know the consumers want flexibility in their payment, and we think we’re going to hit the mark with this one,” McBride said.

PenFed plans to roll out these new “Payment Saver Plus” loans through indirect financing starting in Virginia and Maryland in June, then California in July, Florida in August and through direct lending by year’s end.

The rollout will be accompanied by educational material on PenFed’s website, blog and social media channels.

“We know there’s going to be some education necessary to get consumers more comfortable with what a balloon walk-away product is,” McBride said.

The tradeoff is between the value of extra cash flow for 59 months under a balloon loan, against the loss of the residual value of the vehicle after five years.

Consider a new Jeep with a $41,441 price tag. Jeep prices hold up well, so the residual might only require paying 60% of the price tag before the balloon comes due. With a balloon loan with a 5.25% interest rate and 59 monthly payments of $434, the remaining balloon payment would be $24,147.

With a conventional 60-month loan with a 3.99% interest rate, payments would be $763 per month.

The person taking out the conventional loan has lost the use of $329 a month in cash flow for nearly five years because of higher payments. However, the conventional borrower ends the period with a vehicle worth about $16,500, as well as $1,426 in accumulated interest savings.

If the same choice of deals were available to the drivers at the end of the five-year period, the conventional borrower could apply the trade-in value of his used Jeep against his next new Jeep also priced at $41,441. The buyer now has to finance only $23,438, bringing the monthly payments down to $432 per month, slightly less than the monthly on the balloon loan. Meanwhile, the balloon borrower could again choose another balloon loan for the newest model Jeep, but will then have lost both the monthly cash flow advantage and ownership of the residual.

The monthly payment savings can make sense for some: Real estate agents and others have business reasons to drive a nicer car than their income would otherwise afford. People who expect their income will be significantly higher within five years – perhaps because of the maturity of a long-term investment.

“It really boils down to personal preference,” Leonard said. “It’s not for everyone, but for some, it’s a good way to go.”

PenFed started indirect car lending in 2016, and that channel accounted for only about $600 million of its $1.7 billion in auto loan originations last year. With AFG, PenFed expects to add $1 million to $2 million a month from indirect balloon loans in the first few months, rising to $5 million and then to $10 million after the program is fully rolled out.

Further growth from the walkaway balloon loans will occur when they are introduced in Texas and some northeast states where leasing is more popular, and the concepts of residual financing are more familiar, McBride said.

PenFed’s new car loans as of Dec. 31, 2018 were $1.9 billion, up 7.7%, while the total among all credit unions was $21.2 billion, up 5.9%. PenFed’s used car loans as of Dec. 31, 2018 were $1.5 billion, down 4.4%, while the total among all credit unions was $22.6 billion, up 7.6%.

“The first quarter of 2019 has been a little bit behind what we forecasted because of general softening in the auto market, but I think we’ll catch up as we go throughout the year,” McBride said.