The Two Methods of Calculating Car Loan Interest
Car loans in Australia use one of two methods to calculate interest: reducing balance or flat rate. Understanding the difference is crucial because two loans with the same advertised rate can cost dramatically different amounts depending on which method is used.
Reducing Balance Interest: This method calculates interest on your remaining loan balance at any given time. As you make repayments and reduce the principal, the interest charged each period decreases. Most Australian car loans from banks and mainstream lenders use this method.
Flat Rate Interest: This method calculates interest on the original loan amount for the entire loan term, regardless of how much you have repaid. Even as your balance decreases, interest continues to be charged on the initial borrowing. This method results in higher total interest costs.
A flat rate of 5 percent is not equivalent to a reducing balance rate of 5 percent. The flat rate will cost significantly more. As a rough guide, a flat rate of 5 percent equates to approximately 9 to 10 percent on a reducing balance basis, depending on the loan term.
Understanding Amortisation: How Repayments Are Split
When you make a loan repayment, it is split between interest and principal. The proportions change over time through a process called amortisation, and understanding this helps you see where your money goes.
In the early months of a reducing balance loan, most of your repayment covers interest because the balance is highest. A smaller portion reduces the principal. As time passes, the balance decreases, meaning less interest accrues each period. More of your fixed repayment then goes toward principal reduction.
For example, on a $30,000 loan at 7 percent over five years, your first monthly payment might allocate $175 to interest and $419 to principal. By the final payment, perhaps only $3 goes to interest while $591 reduces the principal. The total payment remains constant, but its composition shifts dramatically.
Use our car finance calculator to generate a full amortisation schedule showing exactly how each payment is divided throughout your loan term.
The Daily Interest Calculation
Most Australian car loans calculate interest daily, even though you make monthly repayments. Understanding daily interest helps you appreciate the impact of payment timing and extra repayments.
Daily interest is calculated by dividing your annual interest rate by 365 and multiplying by your current balance. For a $25,000 balance at 7 percent, daily interest equals approximately $4.79 per day. Over a 30-day month, roughly $144 in interest accrues.
This daily calculation means that paying early saves interest while paying late costs extra. If you make a payment on the 1st of the month rather than the 15th, you save 14 days of interest accruing on the repaid principal.
It also means extra repayments have immediate impact. An additional $1,000 paid today stops that amount from accruing interest from tomorrow onward. Over the remaining loan term, that single extra payment can save hundreds of dollars in interest.
Factors That Determine Your Interest Rate
Lenders consider multiple factors when setting your car loan interest rate. Understanding these helps you present the strongest application and potentially qualify for better rates.
Credit Score: Your credit history significantly influences your rate. Applicants with excellent credit scores receive the lowest rates because they represent lower risk to lenders. Poor credit typically results in higher rates or declined applications.
Loan Security: Secured loans, where the vehicle serves as collateral, carry lower rates than unsecured loans. If you default, the lender can repossess the car, reducing their risk and your rate.
Loan Term: Longer loan terms often attract slightly higher rates because they represent greater risk over the extended period. Shorter terms typically secure better rates.
Vehicle Age: Financing newer vehicles usually attracts better rates than older cars. New and near-new vehicles hold value better, providing superior security for the lender.
Loan Amount: Some lenders offer better rates for larger loans. Very small loan amounts may attract higher rates due to the fixed costs of administering any loan regardless of size.
Strategies to Minimise Your Interest Costs
Several strategies can help you reduce the total interest paid over your loan term without necessarily securing a lower interest rate.
Choose a Shorter Term: While monthly repayments increase with shorter terms, total interest paid decreases substantially. A five-year term costs far less in total interest than a seven-year term on the same loan amount and rate.
Make Extra Repayments: If your loan allows extra repayments without penalty, making additional payments directly reduces your principal. This lowers the balance on which interest is calculated, saving money throughout the remaining term.
Pay Fortnightly Instead of Monthly: Making half your monthly payment every two weeks results in 26 payments per year, equivalent to 13 monthly payments instead of 12. This extra payment goes straight to principal and can shave months off your loan term.
Refinance If Rates Drop: If market rates fall significantly below your current rate, refinancing to a new loan at a lower rate can save money. Factor in any fees for breaking your existing loan when calculating potential savings.
Comparing Loans: Looking Beyond the Rate
When comparing car loans, the interest rate is just one factor in determining total cost. A comprehensive comparison considers all elements that affect what you actually pay.
Always compare loans using the comparison rate, which includes most fees alongside the interest rate. Two loans with identical advertised rates might have very different comparison rates due to fee differences.
Consider flexibility features that could save money. The ability to make extra repayments without penalty, redraw facilities, and payment holidays during hardship can provide significant value beyond the raw interest calculation.
Calculate the total cost of each loan option by multiplying the monthly payment by the number of payments and adding any upfront fees. This total cost figure makes comparison straightforward and meaningful.
Our free car finance calculator shows you exactly how different interest rates, loan amounts, and terms translate to monthly payments and total interest paid. Experiment with different scenarios to find the combination that best fits your budget and goals while minimising your overall borrowing costs.
See Your Interest in Action
Use our calculator to see exactly how much interest you will pay over your loan term.
Car Finance Calculator Team
Our team of finance experts is dedicated to helping Australians make informed decisions about car loans. We provide accurate, up-to-date information to guide you through your vehicle financing journey.