How Car Loan Interest Rates Work

Most people start with “what’s the interest rate on a car loan?”, and it’s a natural question with an unhelpful answer, because there isn’t one rate. Car loan rates in Australia are priced to the borrower, the car and the loan, so two people buying the same car can be offered quite different rates on the same day. Understanding what drives that is far more useful than an average. Here’s how car loan interest works, what determines the rate you’re offered, and how to put yourself in a stronger position.

How interest on a car loan is calculated

Almost all car loans in Australia charge interest on the outstanding balance, calculated daily and charged in arrears with each repayment. Early in the loan the balance is high, so more of each repayment goes to interest; as the balance falls, more goes to principal. Two consequences follow:

• Paying extra, or paying out early, reduces the interest you pay from that day forward, because there’s less balance for it to accrue on. Our guide to paying off a car loan early covers the rules and any fees.
• The total interest over the loan depends heavily on the term, not just the rate. A lower rate over a longer term can cost more in total than a higher rate over a shorter one.

The advertised interest rate isn’t the whole cost, either. Fees change the effective cost of borrowing, which is why Australian lenders must also show a comparison rate that folds standard fees in. Our guide to comparison rates explains how to read it.

Why there’s no “average” rate worth knowing

Published averages blend everything from prime new-car finance for strong borrowers to specialist lending for older cars and impaired credit. The spread between those is wide, so the average tells you very little about what you’ll be offered. Lenders price each loan on risk, and the risk is assessed from the factors below. That’s why the useful question isn’t “what’s the average?” but “what determines mine, and which of those can I influence?”

What determines the rate you’re offered

Your credit history. The biggest single factor. A clean file with a track record of on-time payments sits at the lower-risk end; defaults, arrears or a thin file push the other way. Our guide to your credit file explains what lenders see.

Secured or unsecured. A loan secured against the car carries less risk for the lender than an unsecured loan, and is generally priced lower. Our guide to secured car loans explains why.

The car: new, used and age. New and near-new cars are stronger security and generally attract the widest range of lenders and sharper pricing. As a car ages, fewer lenders will take it as security and the pricing reflects the higher risk. Very old cars may only be financeable unsecured.

Loan-to-value ratio and deposit. The more of the car’s value you borrow, the higher the lender’s exposure. A deposit, or a trade-in, lowers that and can improve the offer. We’ve covered this in car loan deposits.

Your income and commitments. Lenders assess serviceability: whether the repayments fit comfortably alongside your existing commitments. A comfortable margin reads as lower risk.

Loan purpose and structure. Consumer loans and business loans are priced and regulated differently, and structures such as a balloon payment change the risk profile over the term.

The term. Longer terms can attract different pricing from shorter ones, and they always increase total interest, because the balance is outstanding for longer.

The lender. Each lender has its own appetite. A lender that specialises in, say, self-employed borrowers or older vehicles may price that segment more keenly than a bank that doesn’t want it. This is the factor most people underestimate, and it’s the reason comparing lenders matters even when your own profile is fixed.

Fixed or variable?

Most car loans in Australia are fixed rate: the rate is set for the term, so your repayments don’t change. That gives certainty, which suits a purchase you’re budgeting for over several years. The trade-off is that fixed-rate contracts can include an early termination fee if you pay out before the end, to compensate the lender for interest it priced in but won’t earn.

Variable rate car loans exist but are less common. The rate can move with the lender’s pricing and market conditions, so repayments can rise or fall. They’re often more flexible on extra repayments and early payout. Which suits you depends on whether you value certainty of repayments or flexibility to pay the loan down aggressively. Whichever you choose, the comparison rate lets you compare like with like.

How the term changes the cost

Because interest accrues on the balance for as long as it’s outstanding, the term is the lever most people overlook. A longer term lowers each repayment but increases the total you pay; a shorter term does the opposite. It also affects how quickly you build equity in the car relative to its depreciation, which matters if you might sell before the end. The right term is the shortest one whose repayments fit your budget comfortably, not the longest one on offer. Lenders also cap terms by the car’s age, so an older car may come with a shorter maximum term.

How to put yourself in a stronger position

Several of the factors above are within your control, at least partly:

• Check your credit file first, and correct any errors before applying.
• Don’t apply to multiple lenders. Each application is recorded; several in a short period reads as risk. Get matched to the right lender, then apply once. Our guide to car loan pre-approval explains how.
• Put in a deposit if you can, or a trade-in.
• Choose the car with finance in mind. Newer is easier to finance than old.
• Choose the shortest comfortable term.
• Compare lenders, not just rates. The lender whose appetite matches your profile is where the sharpest offer usually is.

Where a broker fits

Since the rate you’re offered depends on which lender you’re matched with, the comparison is the work. A broker looks at your profile, the car and the structure, and compares the panel to find the lender that prices your situation best, then applies once. Our car loans page sets out what we arrange, and how car finance works covers the process end to end.

This article is general information only and does not state or predict interest rates. The rate you’re offered depends on your circumstances, the vehicle and the lender at the time.

Damo Treadgold is the director of Treadgold Finance, an FBAA-accredited finance broker on the Sunshine Coast, arranging car, boat, equipment and business finance Australia-wide.

Frequently Asked Questions