Interest-free car loans: the truth about 0% interest car finance

An interest-free car loan may sound like a good deal, but there are a number of important things to be aware of before signing up for one. Below, we explain how 0% car finance works, as well as some of the potential pitfalls to be wary of. 

If you’re in the market for a new car, you may have seen dealers offering loans with 0% interest. At first, that can seem like an enticing offer ‒ you get to buy a new car, and you can pay off the principal of the loan without any interest attached. It could seem like such a good deal, in fact, that you may well ask ‘what’s the catch?’

In fact, there are a number of things to be aware of before you consider taking out an interest-free car loan. It may be the case that you end up paying an inflated price for the car itself, the terms could well be stricter than for a different type of car loan, and there could be a number of hidden fees and charges packed in.

What are interest-free car loans?

Simply put, interest-free car loans are loans on which there are no interest payments attached, or loans with a 0% interest rate. Interest-free loans are typically offered by car manufacturers directly through their dealerships, as a marketing tactic to get customers through the door. Some dealers may also offer loans with a nominal 1% interest rate, if they do not offer 0% interest car finance.

How do interest-free car loans differ from other types of loans?

Typically, when you take out a car loan, you will be required to pay back the principal of the loan, which is the purchase price of the car itself, along with interest and in some cases fees. Standard car loans can come with a fixed interest rate, which remains the same over the whole term of the loan, or a variable rate, which can fluctuate over the term of the loan.

An interest-free car loan, by contrast, is a loan on which you only pay back the principal. If you take out one of these loans, then you will be required to pay back the principal, typically in fortnightly or monthly increments, but you will not be required to pay any additional interest.

While an interest-free loan means you won’t be making interest payments on the car you buy, it is worth keeping in mind that there may well be other hidden costs built in, in the form of fees and charges, as well as a number of other potential added expenses to be aware of.

While you may think you are signing up for a 0% car loan, you could still end up losing any potential savings in fees, charges and other costs.

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What are some things to be wary of with interest-free car loans?

When it comes to interest-free loans, it is worth keeping in mind that the purchase price of the car may be inflated, and there may be less room to negotiate on price. Similarly, they may come with high fees and stricter than usual terms and conditions, especially relating to the term of the loan itself and balloon payments.

Inflated purchase price

While an interest-free loan means you will save on interest payments, the flipside of this is that you may end up paying an inflated purchase price for the car itself. Lenders typically earn money from the interest that you pay, so if you are not paying interest, your lender might well build the difference into the price of the car itself to help ensure it can still make a profit, making the car more expensive for you than it normally would be.

Fees and charges

If you are considering purchasing a car on interest-free finance, it is worth taking a close look at the contract to be aware of any monthly or annual fees and charges. Carsguide warns that lenders who offer these kinds of deals may build additional fees, charges and costs into the purchase price on a 0% car loan, to make up for the money they are not receiving in interest payments.

Less room for negotiation on price

If you buy a car using an interest-free loan, there will likely not be much room for negotiation on price. This is because, as mentioned above, the lender will usually factor the money they would otherwise make from interest payments into the price of the car itself, and they therefore may not be willing to let you negotiate a lower price.

Low trade-in value for your old car

If you are using your current car as a trade-in to help you buy a new car on interest-free finance, it is also worth being aware that the value you get for your car may be lower than if you were to sell it independently. Once again, this is because the lender will likely want to make up the money it would otherwise earn by charging you interest.

Stricter loan terms

Standard car loans usually come with terms of one to ten years, but it is worth keeping in mind that the terms of interest-free car loans may often be on the shorter end of the scale. This is because lenders may want these types of loans to be paid off quickly, but bear in mind that a shorter term could mean higher monthly repayments for you than if you had taken out a standard loan with interest.

Limited interest-free periods

A dealership may well offer interest-free financing to entice customers through the door, but it is worth keeping in mind that the interest-free period may not necessarily apply to the whole term of the loan. There may be a point when the loan reverts to a higher interest rate, so it is important to be aware of this before signing up.

Balloon payments

A balloon payment is a lump sum you pay to your lender, typically at the end of a car loan. Balloon payments can allow you to lower your monthly repayments over the course of the loan, and make one larger, inflated payment at the end. They are fairly common when purchasing a car through dealer finance, and if you buy a car with an interest-free loan, the loan may well come with a balloon payment.

While balloon payments can be convenient in that the amounts you pay month to month will be lower, it is worth keeping in mind that you will need to budget for a large lump sum payment at the end of the loan term, and this may not be desirable for all prospective car buyers.

What questions should you ask before signing up for an interest-free car loan?

The benefits of interest-free car loans tend to be more limited than they might seem, and largely come down to whether you can negotiate a lower price with the dealer. Therefore, before signing up for one, it is worth asking:

• What will your total repayments be over the lifetime of the loan?
• Can you get the same car for a lower price elsewhere?
• If so, is the dealer willing to negotiate on price to match this?
• Is the dealer willing to offer a guaranteed future trade-in value for your car?

As mentioned above, dealers are typically not willing to move as much on price with a 0% car loan as they normally might with another type of car loan. If you are not able to negotiate a favourable price for the vehicle, it may therefore be more suitable for you to consider a different type of car loan. You may well find that, with a standard car loan, you will pay less over the lifetime of the loan, even with interest factored in, than you would with an interest-free car loan.

Likewise, dealers who offer interest-free finance may also offer a guaranteed price for a future vehicle trade-in, in order to make this kind of arrangement more appealing to buyers. However, it’s also important to think about what you might be able to get for a trade-in elsewhere, to work out whether the deal a lender is offering you represents good value.

When choosing a car loan, it’s helpful to consider all your options, to find the kind of loan that might be most suitable for your needs and circumstances, whether it is a 0% loan or not. Canstar can help you compare car loans, and if you are curious about your options, you may find it useful to engage the services of a professional financial adviser or car loan broker.

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