Check out this complete guide for anyone thinking about getting a new car loan. Wondering how loan interest & 0% APR offers work? Want to know more about the different car loans out there? We’ve got you covered.
How Does Interest on a Car Loan Work Table of Contents
What is a Car Loan?
Simply put, a car loan is a loan that helps you buy a car. Let’s face it – most of us don’t have £5,000 - £10,000+ in cash just laying around to buy a car outright…
That’s why most people need to borrow money to buy a car, which they then pay back, plus interest, over two to five years. There are four main types of car loans - a personal loan, hire purchase, a personal contract purchase, or personal leasing. We cover them in more depth below.
What is Interest?
There are many lenders out there willing to loan you the money you want to buy a car, but they wanna earn cash for their troubles. That’s the interest they charge, as well as fees, that they charge you. It’s a percentage of the sum you borrow that you have to pay back, in addition to the sum.
The interest rate you get determines how much you’ll pay for the car on top of the amount you borrow. The higher your interest rate, the more money you’ll have to pay back over time.
In most cases, you’ll get a better interest rate the more you borrow. You’re also likelier to get a better interest rate if you have a higher credit score.
However, interest can get a little more complicated than it seems at first glance. You also need to take APR into account.
A Quick Overview of APR (Annual Percentage Rate)
So, what is APR? APR stands for Annual Percentage Rate, which are all the costs involved in purchasing the vehicle expressed at an annual rate or, in more simple language – the amount of interest you will pay annually on any money borrowed.
When it comes time to start comparing different finance providers, it’s wise to look at APR rather than just the interest rate alone. It’s a much more accurate way of comparing what you’ll be paying back.
Thankfully, today it’s easy to find the APR (unlike in the past, when some car salesmen would hide the APR so they could charge a higher interest rate). The APR must be displayed clearly on every document and on signage. If you see an interest rate that seems too good to be true, look at the Representative APR instead.
The Representative APR is an estimation of what an average person will pay. It’s important to remember that you might not qualify for the Representative APR. Your specific APR will depend on your credit score and other circumstances.
APR with many third-party lenders usually ends up around 6% - 11%, providing you have a strong credit score. If your credit card is only okay, your APR will likely be around 12% - 19%. Trying to get those lower APR rates can be tricky, and only available to people with top-notch credit ratings. For instance, headline rates of 3.0% APR are usually on unsecured loans (that is, not secured against the car) and are only offered to people with a great credit history.
On the other hand, if you have a low credit rating, you might only be eligible for 20% APR or higher (even up to 50%!). You’ll probably need a guarantor to help secure any car financing in these cases.
Getting 0% APR
But wait – what about all those 0% APR deals you might see advertised online and in big signs at the dealership? These are usually only offered on cars the dealership is struggling to sell. That said, attractive 0% APR deals do come up from time to time, so keep an eye out!
Different Types of Car Loans
There are four main types of car loans out there, so it’s smart to check them all out before deciding on the right choice for your needs. Your choices are a personal loan, hire purchase, a personal contract purchase, or personal leasing.
You can apply for a personal loan from your bank, a building society, or a high street lender. The benefit is that you’ll own the car outright, and you can usually get a good APR. However, you’ll usually need to make larger payments in order to pay your loan back over a shorter term than with other financing options. In addition, you need reasonably good credit to get a personal loan.
Hire Purchase (HP)
Hire purchase is the most straight-ahead car loan – it’s a finance agreement for a specific car. You’ll make payments over a fixed period, and you’ll own the car outright at the end of the payment period. If you default on your payments or your circumstances change, you could lose the car (and mess up your credit). You might be able to refinance your car loan in the future if you want to lower your payments.
Personal Contract Purchase (PCP)
Think of PCP as a more complicated version of HP. That’s because your monthly payments are pegged to the car’s depreciation over time. You start out with a deposit (usually 10%) and sign a monthly payment contract, but you must pay a ‘balloon’ payment at the end of the term if you want to keep it. This is based on the minimum future value of the car. You can also return it with no additional fees and start the process all over again with a new car.
Personal leasing is also known as Personal Contract Hire (PCH), which is kind of like renting your car. You pay an initial deposit (usually 3 – 6 months’ worth of payments) and set a monthly repayment amount, and then you can use the care for the remainder of the term. While wear and tear is included in your fees, you will need to pay for any additional damage. Unlike PCP, there’s no option to buy the car at the end of the term.
Alternatives to Getting a Car Loan
While most people immediately think of a car loan when they want to buy a car, there are other options when you need to borrow money.
Here are some of the most popular alternatives:
- Credit card – If you’re buying an inexpensive car, you might want to use a credit card for the purchase. A lot of today’s cards offer an introductory period with 0% interest, so you might be able to pay back the total sum before that period is over.
- Private loan – If you’re lucky, you might have a family member or close friend who can lend you the money for your car. It’s always smart to write up an agreement so that everyone is clear on the loan terms.
- Money transfer card – Cash is common with private sales, yet you might not have the money on hand. In this case, a money transfer card can be a short-term loan, allowing you to transfer cash from the card to your current account. In most cases, money transfer cards have a 0% introductory interest rate. You’ll want to pay that money back on time, though, because these types of cards have very high-interest rates once the intro period is over.
How Does My Credit Score Affect the Way Interest Works on a Car Loan?
Lenders and banks check out your credit score to figure out if you’re likely to make your payments on time and in full. If you’ve missed payments in the past, you’re a higher risk for them, so they’ll offer you a higher interest rate to make it worth their while.
Similarly, if you’re already carrying a lot of debt, they’re probably going to be pretty wary about your ability to pay them on time. Of course, your credit report isn’t the only thing lenders look at, but it will play a big role in determining the terms they offer you.
Do you know someone who is looking for a new car loan? Share this article with them and make their search that much easier.