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. Before you sign up for one though, it can be important to understand the basics, including what car loans are and how they typically work.

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 loan is one where you offer ‘collateral’ (such as the car itself) to provide more security to the loan provider 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 loans, on the other hand, do not require any collateral. Instead, the lender will rely on your credit score to approve the loan. Unsecured loans generally have higher interest rates than secured loans and you may not be able to borrow as much.

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. 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 fees and charges.

car loan how it works contract
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A fixed rate car loan is where the interest rate is locked in for the entirety of the loan. On the other hand, a variable rate loan is where the lender may change the interest rate during the term. While choosing a variable rate car loan may mean you could pay less interest if rates are cut, it also means 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 diving in.

Some car loan lenders may offer reduced monthly repayments if you agree to pay a one-off lump sum, or 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 before making your decision.

It is 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 out your loan early you may be charged an early termination fee. Check with your provider to see what account fees and charges may apply.

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 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.

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 loan or personal loan with a bank or other financial institution is you may be able to negotiate on the amount you can borrow or length of the term available for the loan to 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, which could make managing your loan a little simpler.

However, it is 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.

car loan how it works banks
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Redraw facility/line of credit

If you have a mortgage on your home, you might be able to dip into your mortgage 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.

However, in saying this, 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 getting finance via a redraw facility or line of credit can mean you are not required to pay off the car as quickly as you’d normally have to. The longer you owe money on the car, the more it could end up costing you 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 investors, who can be individuals or corporations. P2P loans may offer competitive interest rates and have a convenient online application process, however 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.

However, keep in mind that 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 circumstances. 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 ASIC since November 2018.

car loan how it works car dealer
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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. Remember to read the terms and conditions of each loan you’re considering to understand the benefits, risks and fees involved.

Co-authors: TJ Ryan and Regina Collins

Cover image source: maxuser (Shutterstock)

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