Ever wondered why so many wealthy Singaporeans advocate paying full cash for car purchases? Ever wondered what makes your car loan so profitable that dealers add a 'loading fee' to 'push' buyers to take up loans of minimum tenures? The answer lies in the deceptively quoted interest rates.
Now for the non-Finance trained among you, let me go through some basics. The key difference that we are concerned with is that interest rates for car loans (or strictly speaking hire-purchase) are quoted on a flat basis as opposed to a declining basis. Under a flat basis, the interest amount payable is computed based on the total loan amount and multiplied over the years. I am sure this is familiar to all of you who have financed a car before. But, what you may not know is that for other loans such as mortgages, the interest typically is computed on a declining basis. Under this declining method, the interest is applied on the loan amount that is left and not the whole sum loaned. Simply put, as you slowly repay each part of the principal amount borrowed, your interest payable becomes less.
At this point in time, I am sure the question on everyone's minds is "So what?" Well, the implication of a flat basis interest rate is that it disguises the true or real interest rate that you are paying; making you think that you are paying a much lower interest rate than you really are. Let me provide an example:
Let us assume that I buy a car at $100,000, at a full loan for 3 years. For simplicity of calculations, let us assume an unrealistic interest of 10%.
Based on the flat basis, my total interest is $10,000 per year. This makes my total interest $30,000 and the total sum owed $130,000. My monthly repayment is roughly $3,611. But let me input all this into my financial calculator to obtain the effective annual interest rate (or what I call the real interest rate that I am paying). It turns out that my effective annual interest rate is a hefty 19.46% or nearly double!
As a contrast, if we apply the sums above in the context of a typical mortgage, my monthly repayment would be roughly $3,226. My monthly installment is more than 10% cheaper! The effective annual interest rate that I pay on the mortgage is also a more tolerable 10.47%.
Of course, I won't be listing out the exact working simply because it would probably bore everyone to tears. And, the extent of deceptiveness will vary as the numbers vary. But this does not detract from my key message: Do not be deceived by the seemingly low interest rates! As much as possible, we should all endeavor to keep the amount that we loan to a minimum. Most importantly, the next time car sales people tell you that it is good to take a loan for the car because you can reinvest your spare cash to obtain better returns, take it with a hefty pinch of salt!