What is an Interest-Reducing Car Loan?
What is a reducing interest rate?
An interest-reducing loan is one where the percentage of interest that you pay each month reduces as each loan payment is made.
In other words, the amount of your interest payment decreases as the remaining balance of your interest-reducing loan decreases.
What does a reducing interest rate mean for me?
The reducing interest rate means that as you pay off your interest-reducing loan, your interest repayments will decrease.
As time passes, the amount of your repayment that goes towards the balance or principle of the loan increases, and the portion that goes toward paying the interest, or costs associated with the loan, will decrease.
You'll only pay interest on the remaining loan balance each month.
A reducing interest rate is more complex to calculate than a fixed interest rate. You will find, however, that a reducing interest rate will mean you pay less in total for your loan.
| Case Study* | ||||
|---|---|---|---|---|
Reducing Interest Rate |
10% |
|
||
| Year | Remaining Loan Balance | Loan Amount Paid | Interest Paid | Annual Repayment |
| 0 | $30,000 | |||
| 1 | $20,978 | $9,022 | $2,594 | $11,616 |
| 2 | $11,011 | $9,967 | $1,649 | $11,616 |
| 3 | $0 | $11,011 | $605 | $11,616 |
| Total |
|
$30,000 | $4,848 | $34,848 |
As you can see by comparing the total amount paid for the loan, with our fixed interest rate example below, you will be financially better off with an interest-reducing loan than with a fixed interest loan.
How does a reducing interest loan compare to a fixed interest loan?
Most car loans and personal loans will have a fixed interest rate.
Your interest is calculated once on the total amount that you borrow.
This means that the proportion of your car loan repayments going towards the remaining loan balance and the interest owing on your car loan will be fixed for each repayment.
| Case Study* | ||||
|---|---|---|---|---|
Fixed Interest Rate |
10% | |||
| Year | Remaining Loan Balance | Loan Amount Paid | Interest Paid | Annual Repayment |
| 0 | $30,000 | |||
| 1 | $20,000 | $10,000 | $3,000 | $13,000 |
| 2 | $10,000 | $10,000 | $3,000 | $13,000 |
| 3 | $0 | $10,000 | $3,000 | $13,000 |
| Total |
|
$30,000 | $9,000 | $39,000 |
Comparing this example to our reducing interest rate loan above, you can see that for a $30,000 at a 10% interest rate, you'll spend $4,152 more on a fixed interest loan than on a reducing interest rate loan for the same amount.
How is a reducing interest rate different to a variable interest rate?
A variable interest rate is different from a reducing interest rate. A variable interest rate is determined by the Reserve Bank of Australia cash rate, current market conditions, and perceived lender risk.
Most car loans are fixed interest rate loans, but you see variable interest rates available for home loans.
A variable interest rate loan is also an interest-reducing loan.
For a home loan, this means that the rate, as determined by the market conditions daily, is applied to the remaining balance of the loan.
This means that as you pay off a greater portion of the principle of your home loan, you'll pay a lower interest payment, and put more towards the loan balance, with your next mortgage payment.
What do I need to look out for?
When you're comparing different car loan options, be sure to find out how your remaining car loan interest is calculated by the lender. If you do find a reducing interest rate loan, you could be better off even at a slightly higher rate.
Be aware of dealer options such as zero interest financing. There will be a point where interest kicks in and applies to your loan, so make sure you know what the rate will be.
If you do find a loan with a really low advertised rate, make sure to check out the comparison rate. This will give you a rough idea of the fees and charges that will apply to your loan.
You can be certain that the lenders won't lend you money for free, so be sure to check the application and account keeping fees that apply to the loan.
Can I get an interest-reducing loan?
The most common example of an interest-reducing loan in Australia is a mortgage.
Most of the other loans that you come across, like personal and car loans, are not interest-reducing loans, so the interest rate that you'll pay remains fixed for the whole loan term.
How else can I reduce my car loan rate?
Though it may be hard to find a reducing interest rate car loan, you can definitely get a car loan that costs less than you might be expecting to pay.
Whether you're looking to minimise the car loan fees that you pay, maximise your borrowing power, or refinance a car loan you already have to get a better deal, contact us at Positive Lending Solutions to compare your car loan options from a panel of different lenders.
*Note: Case studies are for example purposes only. Your car loan may differ.
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.