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How does car financing work?

3 weeks ago
Chasing Cars Team

Around 90% of all car sales in Australia are arranged through some sort of finance, which makes our car loan market extremely competitive. There are loads of choices out there, whether you’re seeking finance through a bank or credit union, a car dealership or some sort of lease agreement.

Research pays off when hunting for the right loan. Online car loan comparison sites are a great place to start but punching in the numbers only tells half the story. Advertised rates are specifically designed to entice new customers and closer inspection of the fine print may reveal some less-than-ideal conditions or limitations.

To put yourself in the best negotiating position, narrow down your car financing options before you visit your local dealership. Car payments are typically the biggest vehicle-related expense in the average Aussie household (exceeding fuel costs, routine maintenance, et cetera), so it makes sense to shop around.

Here are our expert tips to help you answer those important car loan questions:

Car Loan Basics

Firstly, it’s helpful to familiarise yourself with common car financing terms and what they mean. For example:

Loan term

This is the contractually agreed time frame for paying off the car loan. Typical car loans last between two and eight years. Having a lengthier loan lowers the individual payments but also increases the total amount of interest you’ll end up paying over the course of the loan.

Interest rate

This is the number that really matters. It’s the ongoing cost of the loan, expressed as a yearly percentage. It can be either fixed (locked in for the duration) or variable (can go up or down during the loan term).

Repayment frequency

Your payments can be weekly, fortnightly or monthly.

Principal

This is the loan amount you borrow from the bank.

Secured vs. unsecured car loans

A secured loan is one in which the lender uses the purchased car as security against the loan; an unsecured loan does not. Because they involve a greater risk to the lender, unsecured loans tend to have a higher interest rate.[i]

Comparison rate

When comparing different rates for car loans, make sure you’re using the comparison rate (which is the base rate plus all fees and charges, excluding early payout penalties) rather than the base interest rate. By law, Australian lenders must disclose the comparison rate.[ii]

Is it better to get a car loan from a bank or a dealer?

Letting your local car dealership handle your financing keeps it simple by removing you from the negotiating process: they organise everything. Some dealers even offer finance packages to those with a poor credit history.  

This convenience can come with drawbacks, however. A dealer typically adds a margin to normal bank rates so you could end up paying more for your loan. Remember, car dealers don’t make all their money from selling cars – a decent chunk of their profit comes from extras like financing and car insurance.

Banks and credit unions offer quite competitive car loan rates but you still need to shop around and check the fine print. You should compare at least half a dozen.

What is a balloon payment?

A balloon payment is a lump sum you agree to pay your lender at the end of the loan term. What effectively happens is that over the period of the loan, a proportion of your interest payments are diverted into the ‘balloon fund’, so your individual repayment amounts are substantially reduced. Balloon payments might be 30-50% of your total loan amount.

While balloon payments do provide the cash flexibility of lower fortnightly/monthly repayments, they don’t really save you money because you’ll end up paying a higher amount of interest over the life of the loan. There’s also that rather large lump sum that needs be paid at the end of the loan term.[iii]

How is interest calculated on a car loan?

As with most types of loans, a car loan is calculated using a fairly standard formula:

Interest payment = outstanding balance x (interest rate / number of annual payments[iv]

No, you don’t have to be a maths geek – just do what everyone else does and use an online car loan calculator to work it out. What’s important is to have a solid understanding of the different factors that influence your total car loan expenses: the lender, the comparison rate, the repayment amounts, whether the rate is fixed or variable and the loan is secured or unsecured, balloon payments, fees, etc.

As you pay off the loan, your interest payments will shrink because more of your regular payments go toward paying off the principal.

Naturally, your interest payment is the most important ingredient but it’s not the only thing to think about. Does your loan require an application fee? Are there missed payment fees, default fees, monthly service fees or any other charges you should know about? Are you able to make extra voluntary repayments without being charged for the privilege? Are there any limits on how old the car can be? These are the kinds of questions you should ask your lender so you get the full story.[v]

How does a novated lease work?

A novated lease is an agreement between you, your employer and a finance company – it’s also referred to as salary sacrificing. Your employer agrees to make car lease repayments directly to the finance company on your behalf, using an agreed-upon proportion of your pre-tax salary. Not all employers offer the option of a novated lease, so it’s always best to check.

These agreements must be made before your salary goes into your account and all terms and conditions should be in writing between you and your employer. A typical novated lease lasts from 1-5 years and normally gives you a choice in the car you’d like to lease.

At the end of the prescribed lease period, you may have the option to:

  • Buy and keep the car by paying off its residual value
  • Trade in your current car and upgrade to a new model
  • Extend the current lease
  • Sell the vehicle and use that money to pay off the residual value

One of the main advantages of entering into a novated lease arrangement is that it can lower the amount of tax you pay each year. Also, GST doesn’t apply to novated leases like it does to other types of vehicle purchase. This means your leased car’s purchase price can work out at least 10% lower than if you had bought the same vehicle outright. As with any such agreement, of course, the devil is in the detail. Make sure you know what fees, conditions and repayment interest rates are involved.

Although there are attractive tax benefits to a novated lease, it’s still a lease – technically, you don’t own the car and can’t make any alterations to it. And unless you renew the lease, you’ll have to pay off the residual value when the lease period ends.

Another point to consider is what happens to a novated lease if you lose your job. Sometimes it’s possible to take the lease with you when you change employers and sometimes it’s not: always check this detail on your lease agreement. If you can’t take it with you when you leave, you’ll be liable for payment on the vehicle.[vi]

Is it better to buy or lease a car?

Tax advantages aren’t the only plus with a novated lease. Compared to a typical car repayment, a monthly lease payment is often cheaper. It’s also a cinch to upgrade to a new car every few years when leasing. Your agreement may include goodies such as a discount fuel card and/or maintenance package.

On the downside, you don’t own the vehicle – you’re just ‘borrowing’ it. There may also be restrictions on how many kilometres you’re allowed to drive it within a set period. You might also find that a habit of continual car leasing over several years can end up costing you more than simply buying a car, taking out a loan and keeping that same car for a decade or more.

When you buy a car with a car loan, it becomes your asset. Each loan repayment increases your equity in the vehicle. You can drive it as much or as little as you like and modify it or sell it. Keep in mind that as the owner, however, you’re also responsible for any repair bills and will have more of your money tied up in a rapidly depreciating asset.

As a general rule, the longer you plan to hang on to a car, the more financially advantageous it is to buy rather than lease. However, if you feel you can commit to the entire term of a novated lease agreement and it suits your circumstances, this can potentially save you a fair bit of money by reducing your payable tax. Just be aware that if you lose your job, your novated lease becomes a consumer lease and you lose those tax deduction benefits. If you’re unsure about which car financing option is best for you, consult a financial adviser for advice.[vii]

Quick car financing tips

The world of car financing isn’t too hard to navigate if you keep it simple with these three tips:

Do your research

Look into the alternatives, compare ‘apples with apples’ and make up your own mind based on facts, not emotion. Use a car loan calculator, visit a few different  financial institutions and make sure you understand all the conditions and fees that come with dealer finance, a car loan or a lease arrangement organised through your employer.

Stick to your budget

Car financing may be your biggest car-related expense but it’s not the only one. Make sure you allow for ongoing maintenance, registration, fuel, insurance and unexpected repairs in your finances. Only choose a car loan you can realistically afford.

Work on improving your credit score

Australian car loan providers are wary of people with a bad credit history and may decline your loan application if you’ve demonstrated poor financial habits in the past. The best way to boost your credit score is to pay off loans on time and to clear as much of your debt as possible. If you have no credit history, consider opening a bank account. Potential lenders can then at least check your balance and transaction history to decide whether to offer you a loan.


[i] https://www.macquarie.com.au/car-loans/secured-loans-vs-unsecured-loans.html

[ii] https://gorapid.com.au/resources/information-centre/what-is-a-comparison-rate

[iii] https://www.savings.com.au/car-loans/what-is-car-loan-balloon-payment#:~:text=A%20balloon%20payment%20or%20%E2%80%9Cresidual,of%20the%20car%20loan%20term

[iv] https://www.savings.com.au/car-loans/how-is-interest-calculated

[v] https://moneysmart.gov.au/loans/car-loans

[vi] https://www.canstar.com.au/car-loans/novated-lease/[vii] https://www.savings.com.au/car-loans/car-loan-versus-car-lease

Disclaimer: This information is general in nature only and does not constitute credit or personal advice. While Chasing Cars has endeavoured to ensure the information we’ve relied on is accurate and current, we do not guarantee it and accept no liability for this information. Chasing Cars recommends you obtain specialist advice specific to your individual circumstances before purchasing any motor vehicle.

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