What does the interest rate on your car loan mean to you?

A car loan seems relatively straightforward; your lender pays for the car and in exchange, you pay back what you borrowed plus a little bit more. That little bit more is the interest, and how much extra you pay depends on what kind of car loan you took out. It would be easy to assume that your weekly, fortnightly or monthly payments pay off equal amounts of capital and interest, but in reality it’s not quite that simple.

Compound interest: How the numbers work

Car loans in Australia use compound interest, where the rate of interest you are paying is calculated on principal (the amount you are borrowing) plus whatever interest has already been accrued. If you borrow $20,000 at 7.99 per cent interest ratefor a five year loan term, you might think that you’ll be repaying the $20,000 in addition to $7,990 in interest (7.99 per cent of $20,000 for each of the five years in your term), making the principal plus the full interest amount $27,990. It would be easy to assume that this is just a new total, however this is not the case.

A $20,000 loan with a 7.99 per cent interest rate would require repayments of around $405 a month (this is an estimate). You may have noticed that $405 multiplied by sixty months doesn’t add up to our formerly established total of $27,990. This is because the interest rate is calculated daily and the total is charged against your balance (principal $20,000 plus interest 7.99 per cent) at the end of each month. So in your second year, the interest will be calculated at 7.99 per cent of your remaining principal and interest – this means that your true total is well below $27,990.

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What is the pay-off curve?

So what is your total? At the end of your five year term, the total you will have paid is $24,325 – $20,000 to pay back your original loan amount (principal), and $4,325 in interest. While your monthly repayments will be the same every time, they are actually paying off a slightly different ratio of principal and interest each month.

The interest you pay is front-loaded in the early payments. This means that the beginning or your loan term is where you pay the most interest. So in your first month, you might pay $300 principal, and $105 interest. In the second month, you might pay $302 principal, and $103 interest, and so on. Because every time you make a payment, the principal is lower and therefor, every month you will have less interest to pay off.

Interest rates and your car loan

It is important to keep in mind that interest rates aren’t the only thing that will affect how much you pay for your car over your loan period. The length of your loan should also factor in. Although a longer loan period means lower regular repayments, it also means you’ll pay more interest over the longer term.

In the running example we’ve been using, the interest came to $4,325 over the five year loan period. If that were extended to a seven year period, the total interest would be approximately $6,176. So while you may tempted by lower repayments, it’s actually costing you more in the long run. It should also be noted that there can often be fees associated with taking out a car loan, so be sure you speak to your lender to work out how these costs will figure into your car finance.

Beyond Bank has a range of car finance options to suit everyone, so contact us today to apply for a car loan.