When it comes to purchasing a new vehicle, it can be your choice of car loan and car loan interest rate that makes the biggest difference in terms of overall costs and potential savings. Interest-reducing loans can be confusing to start with, but they’re worth wrapping your head around because they have the potential to save you thousands of dollars down the road.
So, what is an interest-reducing loan?
An interest-reducing loan means the amount of interest you pay off each month reduces as each repayment is made. In other words, your interest decreases as the loan amount gets smaller. For consumers, the benefit is that, over time, you pay less in total than with a fixed rate loan.
Is an interest-reducing loan the same as a variable-interest-rate loan?
They are actually two separate items. One is talking about the amount of interest being reduced based on the amount you owe at the end of each month and the other is talking about the interest rate applied to that balance at the end of the month. Car Loans are generally fixed interest rate, which means the interest rate does not change, but the amount of interest charged to the facility at the end of each month varies depending on the balance of the loan at the time. So, it’s in your interest to make extra payments, lump sum payments or just pay that little bit each extra, each week, fortnight or month. Variable car loan interest rates have shown up over the last couple of years, so there is the option to have a variable interest rate, instead of a fixed rate. Variable interest rates are also interest-reducing loans as interest is calculated at the end of each month based on the loan balance at the time.
An example of an interest-reducing loan, with a fixed interest rate
Let’s say you get approved for a loan for $10,000 with an interest rate of 8% per annum. Now let’s say that after two years, you’ve paid off $5,000 of the principal loan amount. At the start of the loan, you were paying 8% of $10,000 (equating to $800 per year in interest, worst case scenario), whereas right now, you’re paying 8% of $5,000 (equating to $400 per year interest, worst case scenario).
The more payments you make, the more your balance reduces, meaning less and less of each payment comprises interest as time goes by - even though the interest rate remains the same. In fact, whatever your balance is at the end of each month, that's what you pay your interest on. All rates are fixed, but the amount of interest you pay reduces.
The flexibility of car loans
About 20 years ago, regulations around car financing changed to become a whole lot more flexible for the consumer. Once upon a time, if you wanted to pay out your car loan early, the lender would charge you the total amount of interest on the loan for the full term plus an exit fee (usually around $3,000).
So how does it work now?
Let’s say you borrowed $20,000 for a vehicle. Just after settling the loan, you receive a $5,000 tax refund and you decide to use that to pay off extra on your loan. That means, at the end of month one, you are now charged one month’s interest on $15,000 (not on $20,000) and that gets added to your loan amount. This then continues to occur throughout the interest-reducing loan period. So, at any stage during the loan term, you can pay extra (or sell the vehicle) and only pay interest on the amount that’s left on the loan.
Some lenders have no exit fees on car loans, and some do but they are pro-rata. This means that, if you signed up for a 5 year loan and the lender had a $750 exit fee pro-rata, you would only pay $375 if you exited 2.5 years through the loan term.
These days, car loans offer huge benefits to customers:
You know upfront what the worst case scenario of the amount of interest will be throughout, as it’s a fixed rate (for example, 10% for the entire loan term).
You’re not locked into a contract.
You can pay off the loan weekly, fortnightly or monthly to suit your circumstances.
You’re only charged a small fee to exit the loan and some lenders offer this as pro-rata.
Wholesale network vehicles at Rapid Finance
Did you know that, through our extensive wholesale network, we offer customers a one-stop shop to help you source the perfect vehicle for your needs?
Through our network, we will do extra checks on your behalf, including checking that the vehicle is in great condition.
We will also check:
That there is no money owing on the vehicle.
That the vehicle has not been a repairable write-off.
That the vehicle has not been in any serious accidents.
We will check if everything works on the vehicle.
We will get a roadworthy for the vehicle.
We will do a detailed inspection of the vehicle.
Find out more info about our wholesale network vehicles.
Searching for a lower car loan interest rate?
At Rapid Finance, we've been helping Australians find suitable car finance since 2001. And, we could help you too - even if you have a less than perfect credit history.
Our experienced finance specialists can find and compare a wide range of loans to seek a solution that is right for you and your circumstances. Call us today on 1300 467 274