How Interest Rates Apply to Car Loans
When you take out a loan, you'll notice that different lenders will promote their interest rate to get you to apply for a loan with them rather than a competitor.
But why is the interest rate so important? To find out, we'll take a look here at how interest rates work, and how they are calculated and applied to your car loan. Here's what you can do to ensure you don't end up paying too much to borrow a lump sum to purchase a car.
When do you pay interest on car loans?
When you borrow money for any reason and repay it gradually, you'll pay interest on the loan balance until it has been paid in full.
How do you pay interest on car loans?
Interest is usually paid as a portion of your car loan repayment amount each week, fortnight or month.
Your repayments remain fixed for the loan term, but you pay interest and principal off in different amounts each month. At the start of the loan term, you'll pay more towards interest costs, and as the principle on the loan decreases over time, you'll increase the amount allocated to paying the principal.
(see the chart I created in Notes which will be inserted here to illustrate this).
As this chart demonstrates, car loan interest rates are currently low, so the interest that you pay against a car loan will be a small proportion of your monthly payment.
How does the loan term affect the charges?
When you take out the loan over a longer term, you'll end up paying more interest.
Interest is calculated daily, against the loan balance that's outstanding, and is usually applied to the loan account monthly.
The longer that the loan balance remains unpaid, or the longer the loan term selected, the more interest is charged to the loan account.
How can I reduce my interest costs?
You can reduce your interest costs by selecting a loan term that enables you to pay back the balance of the loan as quickly as possible, with repayments that fit into your weekly spending allocation.
To do this effectively, consider how much you'll borrow to purchase a car. You might consider:
- Buying a cheaper or smaller car
- Putting a deposit towards your car purchase
- Buying a used car
Borrowing a smaller amount will allow you to repay it faster, and pay less interest in total.
A new car does come with some benefits, like a lower interest rate applied to the car loan, and up to date safety features, so you may decide it's worthwhile using a car loan to purchase a new car.
Paying out the car loan early
Paying down your loan sooner will reduce the interest paid. Check that your lender allows early payout without a penalty before you do this. A payout penalty will often negate the interest saved by closing your loan account ahead of the loan term.
Get the right car loan the first time
The best way to maximise the benefit you get from your car loan and minimise the interest you pay is to make sure that you get the right car loan the first time.
If the car you buy is to be used for business under an ABN more than 50 per cent of the time, you need to consider a chattel mortgage. Business car loans often attract lower interest rates, but remember that it's more than just the interest rate that affects the cost of car loans.
You have to consider fees that apply to the loan, and the 'opportunity cost' of committing part of your income to the car loan repayments.
Arranging your car finance with a car loan broker will allow you to compare different car loans, seek expert advice on the most appropriate funding based on your financial profile.
Some other things to consider when buying a car using a car loan include:
Tom Caesar is the Managing Director of The Positive Group, a group of Australian financial services companies offering a broad range of finance to clients Australia wide. The Positive Group assist clients in the areas of car finance, mortgages, insurance & wealth management. Tom has been in car & asset finance for over 10 years. Tom regularly contributes articles on car finance, insurance, technology and business growth, drawing on his experience of starting his own brokerage in 2009.