Why Your Car Loan Interest Is Secretly Double What It Seems

Your car loan may advertise low interest rates, but the real rate you're paying could be twice as high.

A common point of confusion, when it comes to loans, is the different ways interest rates are calculated. This is especially true when it comes to car loans – if you tally the amount spent at the end of the loan, it seldom matches the advertised rate.

Why Are Car Loan Rates More Expensive Than They Seem?

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 Rate Method.

With a Flat Rate Method, the amount of interest that you pay is fixed, based upon the original principal.

For example:

• You take out a car loan of S$84,000
• The advertised interest rate is 2.78% p.a.
• The loan tenure is 7 years

Using the Flat Rate Method of calculation, the interest you pay is based on the original principal of S$84,000 every month. So the total interest payable over 7 years is:

2.78% x S$84,000 x 7 = S$16,346.40

Now, added to your initial loan of S$84,000, the total amount you need to repay = S$100,346.40

This works out to [S$100,346.40 / (7 x 12)] = S$1,194.40 every month for 7 years

How Does This Differ From Other Loans?

For most other loans, such as home loans and personal instalment loans, the interest is calculated based on the outstanding balance every month. This means that as you pay down the loan (a process called amortisation), you will also progressively pay less interest. This is referred to as the Reducing Balance Method.

Read more: Reducing Balance Method: What It Is and How It Saves You Money on a Personal Loan

With a car loan however, the interest is based on the original amount borrowed; it doesn’t matter how much you have already paid down.

Taking our earlier example, here is the expected difference between Reducing Balance vs Flat Rates:

*Figures for Reducing Balance rounded to the nearest dollar and based on this calculator

As you can see, the total interest paid for a Flat Rate loan is almost twice as much as that of the Reducing Balance loan – that's why your car loan interest is secretly double its advertised rate!

Why Does Car Financing Work Like This?

The main reasons are that:

1. this has always been the way car loans have worked, and the incumbents are not exactly incentivised to change this; and
2. the car loans industry is full of exotic and obscure loan facilities.

Some people, for instance, obtain financing from their auto-dealer instead of the bank. The auto-dealer may be providing the loan themselves, or work with a third-party to provide financing.

These obscure credit sources are not as well regulated as banks and financial institutions; some may have gone unnoticed by authorities with regard to how they advertise rates.

Remember that a Flat Rate of 1.88% p.a. is still more expensive than an EIR of 3% p.a.!

Compare and apply for car loans through SingSaver

Before you commit to any loan, be sure to shop around for the best interest rates in the market. More importantly, as our example above as shown, you should always remember to take the EIR into account.

Banks and financial institutions are required by law to indicate the EIR of their loans next to the advertised interest rate. For example, you may see an advertisement such as “personal instalment loans at just 3.5% p.a. (EIR 7% p.a.)”. This helps provide transparency as to the real interests you will incur.

But other organisations, including auto-dealers and licensed moneylenders, are not bound by this law. This makes it easier for them to conceal by omission the true costs of taking a loan.

When faced with such situations, calculate the EIR from the advertised rate for a more accurate representation of how much you'll actually be paying for the loan. The formula is a little complicated, but you can just use an online calculator to do it.

Alternatively, here’s a quick rule of thumb: the EIR is about double the flat rate. This means that a car loan with an interest rate of 2.78% p.a. would have an EIR of close to 5.56% p.a.

Read these next:

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Are You Ready to Get a Car Loan in Singapore?
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7 Factors to Consider Before Buying a Car in Singapore