Your car loan may advertise low interest rates, but the real rate you’re paying could be twice as high.
A common point of confusion, when it comes to loans, is the different ways interest rates are calculated. This is especially true when it comes to car loans – if you tally the amount spent at the end of the loan, it seldom matches the advertised rate.
Is this a scam? Not really, it’s just due to the way car loans work.
Why Are Car Loan Rates More Expensive Than They Seem?
When it comes to car loans, the stated interest rate is not the same as the real interest rate (called the Effective Interest Rate, or EIR). This is because car loans always use what’s called a rest rate.
With a rest rate, the amount of interest that you pay is fixed upon the principal. For example, say the loan amount is S$84,000, and the interest rate you pay is 2.78 per cent per annum. The loan tenure is for seven years.
Using the rest rate method of calculation, the interest you pay is based on the principal (the original loan amount) of S$84,000 every month. So the interest payable works out like this:
2.78 per cent of S$84,000 = S$842.78 per year, in interest payments
Total interest paid over seven years is thus S$842.78 x 7 = S$5,899.46
Now, added to your initial loan of S$84,000, the total amount you need to repay is (S$84,000 + S$5899.46) = S$89,899.46
Divided over a period of 84 months, that comes down to (S$89,899.46 / 84) = S$1,070.23 per month.
How Does This Differ From Other Loans?
For most other loans, such as your home loans, the interest repayments are based on the outstanding balance every month. This means that, as you pay down the loan (a process called amortisation), you will also pay less interest. (As you can imagine, this can result in quite a large difference by the end of the loan.)
With a car loan however, the interest is based on the original amount borrowed; it doesn’t matter how much of it you’ve “paid down”.
There is a formula to convert a flat rate loan, such as a car loan, to an Effective Interest Rate (EIR). As it’s a little complicated, you can just use an online calculator to do it. Alternatively, here’s a simple rule of thumb: the EIR is about double the flat rate.
For example, a car loan with an interest rate of 2.78 per cent per annum would have an EIR of close to 5.56 per cent per annum.
Wait, Why Does the Car Loans Industry Get Away With This?
The main reasons are that (1) this has always been the way car loans have worked, and maybe not everyone is aware enough to have collectively complained, and (2) the car loans industry is full of exotic and obscure loan facilities.
Some people, for instance, obtain financing from their auto-dealer instead of the bank. The auto-dealer may be providing the loan themselves, or in turn working with a third-party to provide financing. These obscure credit sources are not as well regulated as banks and financial institutions; some may have gone unnoticed by authorities with regard to how they advertise rates.
Tread with caution, when getting auto-dealer loans. Remember that a flat interest rate of 1.88 per cent is still more expensive than an EIR of three per cent!
What Other Loans Work This Way?
Again, banks and financial institutions will state the EIR next to the nominal interest rate. For example, you may see an advertisement such as “personal instalment loans at just 3.5 per cent per annum (EIR 7%).”
More shady organisations, however, may try to conceal “payday loans” or “instant credit” interest rates this way. When considering loans like these, always remember to take the EIR into account.
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By Ryan Ong
Ryan has been writing about finance for the last 10 years. He also has his fingers in a lot of other pies, having written for publications such as Men’s Health, Her World, Esquire, and Yahoo! Finance.