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Understanding car finance
Finance

Understanding car finance

Currently, there are hundreds of credit providers queuing up to lend you money to improve your lifestyle or get you out of a bind ... or so it seems.

But as you can imagine, not all credit providers are created equal.

That's why it pays to know what you're getting into before you sign any credit contract. While knowing the interest rate you will pay on the money you borrow (and any extra charges) is obviously paramount, other terms and conditions placed on the loan will also impact whether or not the loan is right for you.

Since 25 September 2020, all credit licensees (lenders) must comply with the responsible lending conduct obligations in Chapter 3 of the National Consumer Credit Protection Act 2009 (National Credit Act).

The responsible lending obligations include:

  • making reasonable inquiries about the consumer’s financial situation, their requirements and objectives;
  • taking reasonable steps to verify a consumer's financial situation;
  • making a preliminary assessment or final assessment about whether the credit contract is ‘not unsuitable’ for the consumer;
  • if a consumer requests it, being able to provide the consumer with a written copy of the preliminary assessment or final assessment.

In other words, finance institutions should not be lending you money you can't afford to repay.

What is a car loan?

A car loan is a form of personal loan that you take out expressly for the purpose of buying a car – whether it’s a sedan for the family, a ute or van for work, or a 4WD for weekend adventures.

The loan includes the amount of money you wish to borrow plus the interest you pay for borrowing it. As an example only, if you were to borrow $25,000 at 4.99% over a three-year period on a secured loan (see below), you would need to repay $187 per week (as total of $1965 interest), plus any fees associated with the loan, such as administration. (for illustrative purposes only).

What is a comparison rate?

A comparison rate is a percentage rate that all finance providers must display by law. It must appear next to their advertised interest rates. It includes most of the fees and charges that accompany the loan, that way there are no hidden costs and you’re fully informed about what you’ll have to repay.  As an example only, an interest rate of 4.99% plus administration and set up fees could work out to have a comparison rate of 5.13% (for illustrative purposes only).

What are ‘Secured’ and ‘Unsecured’ car loans?

A ‘secured’ loan is where the borrower backs the loan with some collateral (such as the vehicle itself and other assets the lender may take or force you to sell to repay the loan in total if you break the terms of the loan. Though, in reality, no-one wants to go down this path if they can avoid it. Lenders would rather offer you a loan you can afford to repay without any hassles.

An ‘unsecured’ loan has no collateral attached to it. Typically, the lender will use your credit score to determine whether you are a good chance of repaying the loan. These types of loans usually have higher interest rates because the risk to the lender is greater.

Secured and unsecured loans typically have ‘fixed’ interest rates where the rate will remain the same for the entirety of the loan term.

What is a credit rating or credit score

A good or bad credit score will help determine your risk profile for a lender, which apart from agreeing to finance you (and how much) or decline to, can also impact what interest rate they will charge you.

Popular website Equifax considers a score between 666 to 755 to be ‘good’ and a score between 756 to 840 to be ‘very good’. Get above that and you’ll rate an ‘excellent’. The higher your rating, the less chance there is of you defaulting and the lower the risk you present to the lender. Therefore, you should also attract their best interest rate.

Things that can impact your credit rating include if you’ve ever been declared bankrupt, defaulted on any previous loans, are a consistent late payer (or miss payments), you don’t have any savings, your credit card is constantly maxxed out, or you’ve been refused finance in the past*.

*Shopping around for finance, being rejected and deciding to try elsewhere for a better interest rate, for example, can also affect your credit score. If you visit a handful of lenders in a 2-week period and don’t go with any of their offers, your credit score could drop. That’s another reason to know what to expect from lenders and to have your affairs in order.

Lenders will also want to know your employment status and salary.

As mentioned, if you have a poor credit score an advertised interest rate of, say, 4.99% might not apply to you. That advertised rate is possibly the optimum rate (lowest) that the finance company is willing to charge someone whose financials stack up and have a great credit rating, good credit history, sound employment and a few other factors that lending institutions will seek.

How to improve your credit score

The best tips to improve your credit score (and increase your chances of getting a loan with a good interest rate and terms if you need to) are to pay your bills on time, keep your credit card balances below 25%, make regular repayments, don’t have lots of unnecessary bank accounts and credit cards. These could be seen as way to borrow more money in the future and increase your risk of repaying the finance you are applying for.

All things being equal, having a great credit score isn’t the only way to get a good finance deal, but it helps.

Balloon payment options

A finance option you may consider is one with a balloon payment. Rather than repay the total loan in equal payments, you can elect to make smaller incremental payments for the term of the loan and then make one large final payment (it might be when you intend to sell the vehicle).

A good finance advisor could help you work out what the expected value of your vehicle would be at the end of the term, depending on the condition of the car mileage, etc.

The ATO website also has a depreciation schedule for vehicles so you can see what the ATO believes your vehicle cost would depreciate over time. (this will depend on the condition of the vehicle, etc).

‘Claw backs’

Some finance providers may have early payout fees attached to their loans (to make up for the loss of interest payments they receive if you decide to cash out the loan prematurely. These are called ‘claw backs’. Check if your loan has any of these clauses before you sign in case you wish to pay out the loan early.

Mistakes to avoid

The biggest mistake people make when applying for a car loan is not having a firm budget and a grasp on what they can afford to repay. This can go two ways:

  1. they over-extend themselves and their new vehicle becomes a burden, not the joy they were anticipating; or
  2. they under-estimate what they can afford to repay and purchase a cheaper car that they realise (when it’s too late) doesn’t meet their needs or expectations.

To make sure that this doesn't happen to you, get your finances in order first, so that when you meet with a credit provider (in person or online), they’ll have an idea of what you can afford to repay – because they will check! This will save all parties time and avoid any unnecessary hassles and negative hits on your credit file.

Credit providers will want to have access to your ALL your financial statements just like your bank manager or accountant would – bank statements, recent payslips (for you and possibly your partner if you have a joint account), any other regular income or expenses. This will show whether in the past you’ve been good at saving and, if you’ve had any previous loans or a current mortgage, are good at repaying them. These factors will help determine your credit rating/credit score (check yours at Equifax.com.au) or many other ‘free’ websites.

Budget

Work out exactly what your budget is and then stick to it. One reason for doing this is that it makes sense that the more you spend, the more car you get. And if you don't have a set budget it's easy to think “well, if I just add another $1000 here or $1500 there or even $3000 to $5000, look at all the extras I get”. But then you also have to pay it back and that could put undue stress on your financial situation.

Top 4 Tips (in a nutshell)

  1. Understand your true budget (what can you reasonably afford to repay).
  2. Get your financial information up-to-date (such as your latest tax returns, bank statements, budget)
  3. Know your credit score and is it the best it can be according to your circumstances?
  4. Do your homework on car prices. Just because you can get the finance, is that the best deal you can get on the car you want?