Car loans: Explained simply

Here’s a simple explanation of car loans to get you across everything you need to know.

What is a car loan?

A car loan is when you borrow a sum of money from a finance company to buy a car.

You agree to repay the loan in increments over a predetermined length of time. Breaking down payments into smaller amounts is called amortisation.

Of course, a money lender has to make money, so they charge interest on top of the repayments. You can think of it as a fee you pay to borrow money.

Some car loans come with additional costs. These might include an application fee, a monthly service charge or an early repayment fee (also called an exit fee).

What are the different types of car loans?

There are a few, but some of the most common types of loans are secured, unsecured and dealer finance.

Secured car loan

With a secured car loan, the vehicle you buy is held as collateral against the loan. For the lender, this helps offset some of the risk should you fail to pay back the loan. They can reclaim the car to help recoup some of their losses.

In practice, a secured car loan translates to less perceived risk in the eyes of a lender, so they typically place lower interest rates on this type of car finance. There are a few conditions specific to this type of car loan, though:

• Because a lender wants to mitigate their losses should you stop paying, there are tougher clauses on the vehicle you buy. Often, it means the vehicle has to be between 2 and 5 years old at the start of the loan and no more than 10 years old at the end. Some lenders say the loan must be for a privately-owned vehicle and do not allow commercial use. Lenders want to make sure the car retains enough value to serve as security (or collateral) throughout the loan.

• Some secured car loans tend to require that you spend the borrowed money only on the car purchase, not on things like rego, insurance or unrelated purchases.

In summary, you might get a lower interest rate with this type of loan, which over the loan period can translate into a difference of hundreds of dollars. However, you’re more restricted when it comes to the age of the car you can buy and how you can spend the money you borrow.

Unsecured car loan

As the name suggests, no security is taken on this type of car loan. The lender is accepting a slightly increased risk when they offer you these loans. Therefore, the interest rates tend to be higher – meaning it costs you more to borrow the money.

However, the upside is that there are fewer strings attached to how you can spend the funds. That might free you up to buy an older car that wouldn’t qualify for a secured car loan, let you pay off an outstanding loan or get a different car.

Dealer finance

Another common loan type is dealer finance. Because this is arranged by the car dealer’s finance partner, it’s often very convenient to set up. You walk onto the sales forecourt, pick a car, go inside and the salesperson fills out all the paperwork for you – all while you sip a complimentary coffee.

The ease of taking out dealer finance makes it attractive, but make sure you read through all the terms and conditions and understand the agreement you’re entering into. The dealership may be running a promotion, with incredibly low-interest rates, but the finance might be subject to a balloon or residual payment. This is where you agree to pay a large sum at the end of your loan – making the monthly repayments seem more affordable because the loan is actually for a lower amount than the vehicle’s purchase price. MoneySmart.gov.au says you need to be aware of balloon payments. Do your due diligence and know what you’re agreeing to as well as how much it’ll really cost!

Pre-approved car loans

Getting pre-approval lets you know how much you’ll be able to borrow and under what terms before committing to taking out a loan. It also goes by the name of conditional approval. The application process is similar to taking out ordinary finance.

Why would you want pre-approval on a car loan? It means you can start car shopping with the wheels already in motion as it were. That lets you haggle with the seller because you know exactly how much money you’re able to borrow. You’re not hostage to the dealer upselling you finance or other “special offers” either – you can just get down to haggling. Plus, you have a cap on how much you can spend, which will help you resist all the tempting optional extras.

Just a couple of things to note – the pre-approval deal you receive may only last a fixed amount of time, so it could add a slight sense of urgency to your car purchase. Also, not all lenders offer pre-approval or conditional approval, so you may need to shop around.

There are so many car loans, how do I pick one?

Break it down to a simple checklist. The ideal loan would have the following:

• A competitive interest rate (meaning it costs you less to borrow)

• A low application fee

• An affordable monthly account fee

• Little or no exit fees

• Payment flexibility allowing you to optionally pay back more

• An easy application process

• Repayments that are within your budget

• The ability to get pre-approval, so you can shop around for cars knowing the exact amount you’re eligible to borrow

• Conditions that allow you to purchase the exact vehicle you want

The more of those boxes you can tick, the closer you’re getting to the “perfect” car loan for you.

Written by Ben Gribbin
Ben Gribbin is an experienced automotive writer at Finder and a life-long car enthusiast with a passion for restoring classic vehicles.