How do car loans work?

If you’re in the market for a new or used car, there are a number of financing options available. If you do not have the savings to buy one outright, an option you may be considering is taking out a car loan. But, how do car loans work, what do you need to get one, and how do you qualify for one? Let’s dive in.

What is a car loan?

A car loan is a type of personal loan taken out for the purpose of buying a new or used motor vehicle such as a passenger car, van, truck, motorbike, ute or 4WD. A car loan may also be called a vehicle loan.

These loans may be secured or unsecured. A secured car loan is one where you offer ‘collateral’ (usually the car itself or another asset) to provide more security to the lender in case you fail to repay the money you have borrowed within the agreed timeframe. If the sale of your collateral does not cover the full amount you owe, you will have to pay what is left directly to the lender.

Unsecured car loans, also referred to as unsecured personal loans, do not require any collateral. Instead, the lender will rely on your credit score to approve the loan. You can check your credit score for free with Canstar or via the Canstar app. Unsecured loans generally have higher average interest rates than secured loans and you may not be able to borrow as much.

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How do car loans work?

When you enter a contract for a car loan, the amount of money you borrow has to be paid back within a certain period of time (called a term), usually in regular repayments. The length of the term can vary, typically from around 12 months to 10 years, depending on the lender you choose and the agreement you reach with them. To get an estimate for how much you can expect to pay in repayments, you may like to use Canstar’s Car Loan Repayment Calculator.

In addition to requiring you to pay back the amount you borrow, lenders will also charge you interest on the balance, at either a fixed or variable rate, plus any relevant fees and charges.

A fixed rate car loan is where the interest rate is locked at the same rate for the entirety of the loan. On the other hand, a variable rate car loan allows the lender to change the interest rate during the term, usually due to economic conditions.

While choosing a variable rate car loan may mean you could pay less interest if rates are cut, it may also mean you run the risk of the lender increasing the rates during the term, leaving you paying more for your car loan. As such, it’s important to consider the pros and cons of these rate options before making a decision.

Some car loan lenders may offer reduced monthly repayments if you agree to pay a one-off lump sum payment, often referred to as a balloon payment, at the end of the loan term. Consider whether the total repayments on the loan will be higher with the balloon payment than without, as well as if you’ll be able to afford to pay the large lump sum at the end of the loan, before making your decision.

Another way you can reduce your monthly repayments is by putting down a deposit with the car loan. You usually aren’t required to provide a deposit when applying for a car loan, but if you put down 10% or more of the value of the car being purchased you may be able to have lower repayments and pay less interest overall.

For example, if you were to take out a $20,000 car loan at 7% interest on a five year term with monthly repayments, your repayments would be $396 a month and the total interest over the life of the loan would be $3,761. If you were to put down a 10% deposit ($2,000), your repayments would be $356 and the total interest would be $3,385, a saving of $376 in interest.

It’s also worth noting that, depending on the type of agreement you have with your lender, if you want to make extra payments from time to time and pay off your loan early you may be charged an early termination fee. This fee is charged due to the lender missing out on an agreed amount of payable interest. If you take out a car loan with a redraw facility, you may be able to make extra repayments without penalty. Check with your lender to see what account fees and charges may apply, as well as what loan features are provided.

Your lender may also require you to take out comprehensive car insurance to ensure that the loan can be paid off in the unfortunate circumstances that the car is written off. You can compare car insurance with Canstar.

Who offers car loans?

Car loans may be offered by a range of financial institutions, either as a standalone car loan or as a personal loan that you can use to buy a car.

Alternatively, you could consider options such as redrawing or getting a line of credit if you have a home loan, a peer-to-peer loan from a private lender or dealer finance. The option you choose could have an effect on the interest rate charged and the features provided, so it is worth shopping around for a good deal. You can compare car loans with Canstar.

Car loans through financial institutions

A common option when taking out a car loan is to go through a financial institution such as a bank, building society or credit union. These loans are usually available as either a standalone car loan or as a personal loan, depending on what the bank or institution offers. Customers can usually apply online, over the phone, or at a branch (if available).

One of the potential advantages of taking out a car or personal loan with a bank or other financial institution is you may be able to negotiate the total amount you can borrow or the length of the loan term to better suit your needs. Another potential benefit is that you could borrow from the same place you have your bank account, home loan or credit card with, which could make managing your loan a little simpler.

But it’s important to note that being loyal to your familiar financial institution does not mean you will get the best interest rates. Loans through financial institutions could also carry tighter lending criteria than borrowing from other lenders.

Redraw facility/line of credit

If you have a mortgage on your home, you might be able to dip into it via a redraw facility or a separate line of credit to borrow money to buy a car.

This can have two benefits: home loan interest rates are often lower than car loan interest rates, and having both your home and car loans rolled into one monthly repayment may be a more convenient option that’s easier for some people to budget for.

But a redraw or line of credit purchase could cost you more over time than a standard car loan. This is because the loan term for a mortgage is usually longer than that of a car loan, meaning that you will usually not be able to and/or required to pay off the car as quickly as you normally would. The longer you owe money on the car, the more interest you will generally pay, which could end up costing you more in the long run.

Peer-to-peer personal loans

An alternative option to taking out a personal loan for a car through a financial institution is choosing a peer-to-peer (P2P) lender.

P2P lending is an online platform that essentially cuts out the middleman (your traditional lenders), to allow people to borrow funds directly from private investors, who can be individuals or corporations.

P2P loans may offer competitive interest rates and have a convenient online application process, but keep in mind they can carry upfront and ongoing fees, and may offer shorter loan terms and lower loan amounts compared to traditional lenders.

Car dealer finance

Some car dealerships offer on-site financing through their own lender. A potential benefit of dealer finance is the convenience it can offer in helping you buy and finance a car at the same time, and having the dealer handle the paperwork to process the loan.

But if a dealer takes on the majority of the control in organising the finance for you, it may be difficult to know if you are getting the best deal for your needs.

The dealer may also mark up the price of the car to account for the service of arranging the car loan for you, so make sure to check the details of the contract, including whether any additional fees apply.

It is also important to be aware that flex commissions, which allowed car dealers to increase the interest rates they charged customers in order to get a higher commission, have been banned by the Australian Securities and Investments Commission (ASIC) since November 2018.

What do you need to apply for a car loan?

When applying for a car loan, you are usually required to provide the following:

• Photo identification (ID): This may come in the form of a driver’s licence, passport or proof-of-age card. Some lenders may also require up to 100 points of identification, so you may need to supply additional forms of ID like a Medicare or bank card.

• Details of the vehicle: This can include the vehicle’s make and model, registration number, VIN, overall purchase price and whether it’s new or used.

• Proof of income: You may be asked to supply two or three of your most recent payslips, as well as your employer’s contact information. For those who are self-employed, you will usually be required to supply two years’ worth of tax returns.
  

• Debts and expenses: In order to assess your financial situation, as outlined in Australia’s responsible lending laws, lenders will need to know what your ongoing expenses are, such as utility bills, rent, groceries etc. They will also enquire to see if you have any debts, such as from other loans and/or credit card debt, usually via a credit history check.

What makes a ‘good’ car loan?

Generally speaking, a car loan with the lowest possible interest rate and minimal fees would make for a good loan. Having additional features like redraw facilities could also be an advantage. It can be helpful to also look at a loan’s comparison rate, which factors in fees and can give you a more accurate picture of what a loan is likely to cost you in the long run. But ultimately a good car loan will be one that best suits your needs and financial situation.

Compare car loans with Canstar

Before you consider taking out a car loan, it’s important to research and compare the options available to you, so you can make the right choice for your needs and budget. You can compare new car loans, used car loans, as well as many other car loan options with Canstar. Remember to read the terms and conditions of each loan you’re considering to understand the benefits, risks and fees involved. This can be found in the loan’s Product Disclosure Statement (PDS), Target Market Determination (TMD) and other relevant documentation.

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