The idea of an interest-reducing loan can seem like a contradiction in terms. That’s because:
- Many consumer loans you’d come across, like personal loans and car loans, are not interest-reducing.
- The interest APR (i.e. the percentage of interest you pay on a loan every year) is fixed and does not reduce.
Confused? Don’t worry - so are plenty of other people. That's why we've put together a short guide on interest-reducing loans and how they work...
What's an example of an interest-reducing loan?
Let’s say you get 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), whereas right now, you’re paying 8% of $5,000 (equating to $400 per year interest). 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 still reduces.
So, if you pay the same total amount each month, the proportion of your payment that goes towards interest reduces while the amount you pay off your principal increases.
Is this the same as a variable rate loan?
The idea of an interest-reducing loan is often confused with the term “variable rate” loan - i.e. loans where the interest rate is not fixed. Instead, interest rates on this type of loan may move up or down depending on which way the market goes.
So always ensure you’re comparing like-for-like between fixed rate and variable rate loans.
Whatever your balance is at the end of each month, that's what you pay your interest on.
Also, make sure you’re looking at comparison rates, not interest rates.
By law, the comparison rate must include all fees and charges (excluding early payout penalties) on top of the base interest rate. This is to allow consumers to compare financial products from different institutions, like-for-like.
Why look at comparison rates? If a credit facility is interest-reducing, you’ll also need to know what the effective rate is in order to calculate the benefit if you make extra payments.
What if I make extra payments on an interest-reducing loan?
If you pay extra on your loan, the difference is taken off principal - but your repayment does not change.
Most car loans don't have extra repayment penalties but if they do, you need to determine whether it's worth making those extra payments.
It's also important to remember that for most car loans you are not locked in - you can sell the car or refinance at any point. You can upgrade or downgrade - and a new car loan can be arranged to take care of any difference.
Call us. With over a decade of experience, Rapid Finance has built a reputation of matching our clients with the right lender. And we're happy just to talk you through all your options where interest-reducing loans are concerned. No matter your situation, we can help you find the most suitable loan for you.
Call 1300 467 274 to discuss your situation today.