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Are you being deceived by your car loan interest rates?

By Blogger on 14 Jan 2010

Attached Image: Stack_Of_Money_psd.png
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!

car loans, interest, finance and 1 more...

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  • 1
Fourwheels Jan 17 2010 07:50 AM
thanks the articles. let assume something more realistic

Loan 50k for 3 years at 2.2% flat vs loan 50k for 3 years at 2.2% declining basic, what would be the interest difference that someone will have to pay?
Joyer Jan 20 2010 11:21 AM
I agree that it is better to keep your loan amount as much as to the minimum. If I do not take the loan how much loan rebate I would not going to enjoy? Anyway that amount is definitely less than the interest you would pay.
Blogger Jan 20 2010 01:53 PM
@Fourwheels: The effective interest rate you would be paying for the flat loan you mentioned would be 4.44%. You will also be paying 1,480 per month as opposed to 1,433 under the declining basis, a 3% difference a month!
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Jason8 Apr 18 2012 08:46 PM
Well, I think that a car usually is not a cheap purchase, that's why taking out a car loan is so popular.People take out car loans or cash loans because sometimes you do not have a cash to buy a car, but really need it.I think these advices about car loans everybody who wants to take ou a car loan needs to know, because there are alot of ocassions when you take out a car loan with, as you think,low interest rate, but when you make payments you notice the way this loan takes out money of your wallet.My friend faced such situation and it was awful.That is why before taking a car loan count well how much money you will have to pay and make sure that your lender do not try to involve you in paying deceptively quoted interest rates.
  • 1
 
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