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What is a car loan?

A car loan is a personal loan taken out by people specifically to purchase a vehicle. You can take out a loan to buy both new and used cars.

Car loans can be anything from $1,000 to more than $1 million in some cases. Typically, loan terms last for up to seven years, although some lenders offer extended terms that can be up to ten years. The typical length for a car loan is anywhere from one to five years though.

Car loan interest payments are calculated like interest on any other loan. You take the interest rate (which will be changing if it is variable, constant if fixed) and multiply it by the outstanding amount owed on the loan on each day. You then divide this number by 365 to get the amount of interest due on each day. Interest is normally due at the end of each month, so you add together this figure for all the days in the month to get the interest amount due.

Interest payments go down as you pay off more of the principal loan amount, because the outstanding amount you owe decreases.

What other costs are involved in getting a car loan?

Any loan may involved additional costs beyond the repayments. Some lenders charge application or establishment fees; one off charges for the cost of administrating the loan. There are also frequently arrears fees for missed payments and monthly service fees, among others. Not all providers include charges like this, so this should be one of the things you are assessing when you are choosing a loan. You should carefully go through the terms of a loan to find hidden costs like this.

There are also expenses involved with any new car purchase. You’ll need to pay stamp duty for any change of ownership of a vehicle, as well as ongoing vehicle registration fees, insurance, and running and maintenance costs. Some of these may be covered under various car lease schemes. If you don’t currently own a vehicle, you’ll want to keep these expenses in mind when you are deciding how big a loan to apply for.

What are the advantages of getting a car loan?

Save the cash upfront for other things

Rather than saving a certain amount per month until you have the lump sum you’ll need to buy up front, you can get a car loan, make these payments to your lender instead, and get the car straight away.

Access a better car

By spreading the cost of a car across several years of repayments, you will also probably be able to afford a more expensive, newer, safer or better-equipped vehicle.

Build credit history

By taking a car loan and making sure to make all your payments on time, you give lenders more evidence that you are a safe bet to lend money. This could help your chances of being approved for a bigger sum in the future, like a home loan.

What are the disadvantages of getting a car loan?

Interest costs

Interest costs mean you end up paying significantly more for a car than the drive away price you see on the dealership floor.

Late payment penalties

If you are late with your repayments, you may incur arrears fees or compounding interest.

Risk of losing your car

If you default on your repayments, your credit score will be affected, and if you used the car as security, the lender can take your car as collateral, meaning the lender can take it away.

How does a car loan work?

A car loan is a formal finance arrangement, between three parties: the person buying the car, the person selling the car (referred to as a vendor), and the lender.

There are six steps involved in this process.

1. Search online and compare car loans. Find one that suits your needs.
2. Apply for the loan.
3. If approved, the lender will agree to lend you a specific amount to buy a vehicle.
4. A purchase agreement must be signed with the vendor
5. The lender pays the vendor on your behalf
6. You repay the lender, over the agreed period of time (almost always between one and ten years)

What different types of car loans are available?

There are a number of different ways to finance a car.

Secured or unsecured loans

Secured loans tend to result in bigger amounts and lower interest rates, as the lender has the security of whatever asset you used (often the car itself).

Unsecured loans mean that the bank can’t repossess any of your assets if you default, but usually results in higher interest rates.

A chattel mortgage is a specialist car loan for vehicles used for business.

Leases

Operating leases are more like a long term car rental as you don’t own the car at the end.

Another is a commercial hire purchase. This is an arrangement where the loan provider will take ownership of the equipment or vehicle being financed, and then hire it out to you through regular repayments. Once all payments have been made, ownership automatically transfers to you.

A car lease is similar to a commercial hire purchase, except you do not automatically take ownership once the agreement is completed. You can choose to return the vehicle or pay an additional amount to purchase it.

One popular option is a novated lease. This occurs when an employer pays for the lease of their employee’s car out of their before-tax salary. This can lower income tax payable.

How much can I borrow?

There are many things that influence your borrowing capacity. Lenders will assess your income, usual expenses, assets and any other ongoing debts you have (home loans or other personal loans, for example). Lenders will also check your credit history to see if you have defaulted on payments in the past. They are assessing the risk that you will not pay them back in the future, so if you have had loans in the past that you have missed payments on, they may choose to offer you less money or reject your application altogether.

A car loan can be secured using the car itself or another asset, often a term deposit. The loan is secured to the value of the asset used as security, and the lender can choose to sell this security if you default on payments. Secured loans are more likely to be approved and usually mean reduced interest rates.

Which car loan should I choose?

There are several things you should be considering when you are comparing car loans. The first thing to remember is to always compare like for like products with one another. For example, compare secured car loans with other secured car loans.

You’ll also need to assess the following:

Interest rates

The interest rate will be the biggest factor in how much your monthly repayments are. Interest rates are generally lower for secured loans, and variable-rate loans. They can also vary based on the amount you are borrowing and the repayment time.

Many providers offer reduced rates for certain types of car. For example, if a lender has different loans available for green or electric cars, they will tend to have better rates. Another common distinction lenders make is between new and used cars (you will typically be charged more interest for older vehicles).

When you are choosing your next car, it’s worth keeping this in mind. An electric car may suddenly become much more viable when you consider the reduced interest.

Fixed v Variable rates

A fixed rate means that the interest you will pay is set at a certain rate for the duration of the loan. This makes it easier to budget as you know that the amount you repay each month will not change. You are also protected if, for example, the RBA raises the cash rate and interest rates go up. However, fixed-rate loans can also incur ‘break costs’ if you want to pay out a loan early or refinance. They also tend to have fewer features then variable loans.

Variable rates mean that the interest rate you pay can change at any time. With variable rates, your monthly repayments will fluctuate with wholesale interest rates, so there’s more unpredictability. You will also be impacted by cash rate hikes, although your rates can go down as well as up. Variable rates generally offer more flexibility with refinancing and extra features.

Term length

Choosing how long the loan you have chosen will go for is another important consideration. Naturally, a longer term loan will mean you repay less of the principal each month, so reduces your monthly repayments. However, longer loans also mean you end up paying more interest, as interest is calculated based on the monthly repayments rather than the overall loan amount.

A longer loan also means that your car will depreciate more while still under a finance arrangement. This usually means that you end up owing more money than the car is worth for an extended period. It also means you will have reduced equity if you decide to upgrade once again before the term of the loan is completed.

Fees

As discussed, many car loans will have additional fees that you’ll need to pay on top of your interest and principal repayments. This may include application fees, account keeping fees, early exit or break fees, or redraw fees.

These will vary from lender to lender. A useful method to take these extra charges into account is to compare the comparison rate. As you will see from the comparison table above, the comparison rate is normally a few basis points above the interest rate. It incorporates all of these additional charges to work out a more accurate estimate of your out of pocket expenses. If there is a significant discrepancy between the interest rate and comparison rate for a loan, it normally indicates that there are a large amount of these additional fees involved.

Features

There are all sorts of extra features providers may offer. Generally, more features are associated with higher fees, although this does vary.

Here are some of the most common additional features you may encounter:

Extra repayments

Some loans will allow you to make extra repayments without any penalty fees, whereas others might penalise you. If you think that you are likely to have extra money at some point during the loans term, this is something to prioritise, as you may decide to make additional contributions to pay the loan off faster.

Redraw facility

Some of the loans that allow extra repayments will also allow you to take out any additional funds above your minimum repayments.

Pre-approval

Some lenders will pre-approve you for a loan up to a certain amount, which gives you a better idea of how much you can spend on your new car.

How to apply for a car loan

Once you have a good idea of how much you are looking to borrow, and you have chosen the provider that suits you best, you can apply for most loans online. This process tends to be fairly straightforward, but it is much easier if you have all your documents and identification prepared before you start. Each lender will have different criteria, so you’ll need to check what they will ask for.

Generally, you’ll need to provide your lender with the following:

1. Personal information and identification. This includes your full name, age, date of birth, citizenship information, and what dependents you have. Your drivers licence, passport, birth certificate and Medicare card are all examples of evidence you could provide here. Some lenders may also need to see a copy of your licence to verify that you are allowed to drive the car you are buying.
2. Proof of income. Your lender will need evidence of your capacity to pay the loan. You’ll need to provide bank statements and recent pay slips. If you are self employed, you may need to provide your two most recent tax returns to show your income.
3. Proof of assets and liabilities. Lenders may ask for proof of your assets and liabilities, like any other loans you may have.
   Information about your car and insurance. As some loans are dependent on the type and age of the car, you’ll need to provide the year, make and model. You’ll also need a dealer invoice or contract of sale, as well as information on the vehicles registration.
4. Check your credit score. It’s also a good idea to check your credit score before you apply to get a better idea of whether you are likely to be approved.