Why Car Loan Interest Charges Are Actually Pricier Than What It Seems?
Update: 12th October 2018
Many Malaysians love cars, but do not fully understand how interest rate charges work when it comes to getting a hire purchase (car) loan to buy a car. If you have tried to calculate what you are actually paying and found that it is different from the ‘interest rates’ by the banks, you need to read this.
When it comes to loans, there are different ways to calculate the interest rate you will be paying than the ones displayed upfront by the banks. This is obvious when it comes to car loans – if you tally the amount spent at the end of the loan, it is seldom equivalent to the advertised rate.
Is this a scam? No, it’s just the way car loans work.
How does the Interest Rate an a car loan work?
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 flat interest rate.
With a flat interest rate, the amount of interest you pay is fixed upon the principal. For example, say the loan amount is RM84,000, and the interest rate you pay is 3.4% per annum for 7 years.
Using the “rest rate method” of calculation, the interest you pay is based on the principal (the original loan amount) of RM84,000 every month. So the interest payable works out like this:
Your interest per year would be: 3.4% of RM84,000 = RM2,856.00
Total interest paid over 7 years: RM2856.00 x 7 = RM19,992.00
Now, added to your initial loan of RM84,000, the total amount you need to repay is (RM84,000 + RM19,992.00) = RM103,992.00
Divided over a period of 84 months, that comes down to: RM103,992.00/84 = RM1,238 per month.
In this case, the effective interest rate (EIR) for this car loan is 6.27%. In the simplest words, EIR is the true rate of interest earned, factoring in compounding effect.
Generally, the EIR is higher than the flat interest rate. It is important to find out both before taking on a loan. Read this to learn more about Effective Interest Rate.
For other loans, such as home loans, the interest repayments are based on the remaining outstanding balance every month. This means that as you pay up the loan (a process called amortization), you will also pay less interest. With a car loan, however, the interest is based on the original amount borrowed, regardless of how much of it you’ve already paid.
What about reducing Balance Interest Rate?
Mortgage loan and personal loan, on the other hand, are applied based on reducing balance interest rate as the bank only charges interest on your loan’s remaining balance.
This is a sample calculation for a loan based on reducing balance interest rate. If you look closely, interest paid on a monthly basis is reduced as the remaining debt level drops. This is because the interest charged on the principal loan amount gets lower each month as you continue to pay down your principal loan amount.
Despite being the preferred choice when it comes to a loan, this type of interest is not applied to all credit facilities in Malaysia, at least not for hire purchase loan.
It is possibly because that this has always been the way car loans have worked, and maybe not everyone is aware enough to have collectively complained, or the car loans industry is full of exotic and obscure loan facilities.
When you do start purchasing a car, always keep in mind the interest repayments – would it bean amount that you can pay off comfortably? Take the time to think about it.