How do car loans work? A complete beginner's guide

A beginner's guide to how car loans work
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A car can be a vital part of your life. It's often a source of transportation that you and your family rely on for work, leisure and everyday life. But they are also expensive. In fact, they are the biggest purchase you're likely to make after a house.

So, it's no surprise that 90% of Australians choose to finance their cars through loans.

But with a sea of car loan options out there, what are the important things should you be looking for, and how do they actually work?

We've gathered some information on various loan options to help you find the best match for your situation.

How do car loans work?

If you don't have the funds to pay for a car outright, a car loan lets you borrow the money you need upfront in return for paying the lender an amount of interest over the life of the loan.

Your loan will come with a set of conditions. One of these will be the time period in which you agree to repay your loan, also known as the 'term'. There are generally a few term options available ranging from 2 to 7 years.

The longer the term, the lower your monthly repayments – but it's important to understand that you will end up paying more overall, as you are making more interest payments over a longer period.

Use a car loan calculator to get an idea on how much it would could cost to take out a loan over different loan periods.

Car loan or personal loan, which is better?

A personal loan doesn't restrict what you are borrowing money for and could be a good option if you have a good relationship with your bank.

However, there are significant benefits to taking out a car loan instead of a personal loan.

For instance, a personal loan may be either secured or unsecured. If you apply for a secured personal loan, you must offer up something of equal or higher value as collateral (for example, another vehicle or your home). This means that if you default on your repayments, the lender can claim your collateral as payment instead. Unsecured personal loans don't require collateral, however, the rates are generally higher.

A car loan bypasses this risk by using the vehicle you purchase as collateral and securing the loan amount against it. This means if you default on repayments, the car can be repossessed, but your other assets are safe.

Because car loans are secured, they can offer lower interest rates to reduce the overall cost of your repayment versus a personal loan. It's also easier to qualify for a car loan because the car is offered as collateral, but be sure you understand the terms of your agreement before you sign.

What is a balloon payment car loan?

A balloon loan is a specific type of loan which decreases the monthly repayments, making each instalment much lower, but in exchange you are required to make a larger one-time 'balloon' payment at the end of your loan term. It is important to remember that while the lower payments may fit your finances better, you will need to make the bigger payment at the end of the term.

Depending on your situation, there are a couple of options you can take to pay off that final balloon amount:

  • Pay the whole balloon amount and the car is yours to keep – congrats!
  • Refinance the balloon amount to continue paying smaller monthly payments in order to keep your car
  • Trade-in your car (if your lender allows it). This may incur additional costs, but it is a way to have a new car frequently without a big payout – however your car is never truly yours.

Balloon payments offers both pros and cons, so it really depends on your financial situation, why you need a loan and what your plans are at the end of the repayment term.

How much should I put down as a car loan deposit?

A car loan deposit is an amount you pay upfront to secure your car and the rest of your loan. The advantage of paying a higher deposit is that it will reduce your ongoing monthly repayments. The bigger the deposit you pay, the more options you have, and it can also reduce your interest rate.

However as an ideal, it is good to aim for a deposit amount of around 20%.

Don't forget that if you already own a vehicle, you can trade this in or sell it first as part of your deposit amount.

Which car loan term length is best?

Choosing a term for your repayment is an important consideration. The longer the term, the cheaper the monthly repayments will be. However, this increases the overall repayment amount as you will be paying more interest for longer. So for the best rate, a shorter term is better.

The best thing to do is to work out your finances before submitting your application, and use a car loan calculator to estimate how much the different loan terms would could cost. This way you'll have a clear idea of how much you can afford to repay monthly without stretching yourself too much, while also not under-budgeting your repayments and incurring higher interest rates.

Read our tips on how to get better prepared and how to get a better loan.

What's the best way to compare car loans?

Comparing car loans doesn't have to be hard. Make sure you have some basic information ready, including:

  • The cost of the vehicle
  • The amount you can afford as a deposit
  • How much you can realistically afford per month
  • How you plan to use the vehicle
  • Your financial situation

Once you have the necessary information, do some research on loan options so you can make an informed decision. Our groundbreaking car loan comparison technology takes out all the legwork and finds your best loan matches from 30+ lenders in just 60 seconds. There's no obligation to proceed and unlike other applications, our matching technology doesn't impact your credit score, so you don't need to worry about affecting your credit score unnecessarily with loan applications you may not qualify for. At CarClarity, we do all the checks and only connect you to the lenders that are right for your situation, so you can be sure you're getting the best deal every time.

David Fahim

David Fahim is CarClarity's COO, joining forces with two founding team members that share the same passion of helping customers get the right car loan.

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