The Effect of Compounding Interest on A Car Loan
This table illustrates how paying off a car loan over the long term, even with a low interest rate, can really cost you a lot, much more than a regular secured car loan.
| Buying a $30,000 car with a Loan | ||||
|---|---|---|---|---|
| Loan Option | Loan Term | Interest rate | Interest Paid | Total Cost |
| Secured Car Loan | 5 years | 8.31% | $6,769 | $36,769 |
| Mortgage with Extra Payments | 5 years | 4.3% | $3,393 | $33,393 |
| Mortgage | 25 years | 4.3% | $47,710 | $77,710 |
You can see immediately from this example that if you are adding a car loan to a mortgage, to avoid paying a lot more for your car than you intend to, you’ll have to structure extra payments into your mortgage to repay the amount of the car within a shorter time frame.
So when does it make sense to use a mortgage refinance to buy a car, and how can you avoid the potentially very expensive consequences of this option?
When should I consider combining car loan to mortgage?
There are some very limited circumstances where combining a car loan into your mortgage does make financial sense and will save you a few thousand dollars. This option isn’t for everyone, and if you don’t have the right financial profile, you’ll get a better financial outcome with a regular secured car loan.
If you’re worried about the interest rate that you have on your car loan right now, you might consider refinancing the car loan rather than rolling a car loan into a mortgage.
If you’re still keen to find out more about using your mortgage to reduce your car loan, here’s what you’ll need to consider first:
1. Know your financial type
If you are disciplined with your finances, and you dislike having debts, then rolling your car loan into your mortgage could be an advantageous option.
If you’re unlikely to make more than the minimum payment on the loan, then it’s not going to be a good idea, and could end up costing you twice as much as you paid for the car.
To identify if you have a debt-averse financial personality, consider the following:
- Do you save every pay cycle?
- Do you have an emergency fund in place?
- Do you consistently spend less than you earn?
- Do you have income protection insurance?
- Would you take out a personal loan for a holiday or large ticket purchase?
- How many lines of credit do you currently have?
By taking a closer look at your financial situation, you’ll quickly be able to identify how you relate to your finances now, and perhaps begin to make changes to maximise the way you use your income.
If you answered ‘yes’ to the first four questions, ‘no’ to the fifth, and you have less than three open lines of credit, with one being your mortgage, then you are in a healthy financial position.
If you also have sufficient surplus income to boost your mortgage payments to cover a car purchase, then this option could really benefit you.
However, if you’re living a little more hand to mouth, with not much income left once your bills are paid, or you have some existing personal debt outside your home loan, you’d be better off either purchasing a less expensive car outright or taking out a secured car loan separate to your mortgage.
2. Keeping your debt in one place
Combining your car loan with your mortgage can be an excellent way to keep your payments in one place. As long as you are contributing enough to an extra payment to cover the car purchase, this option can really simplify your finances.
Remember that there are costs associated with redrawing or refinancing your mortgage, so be sure to factor these in when you compare a secured car loan option to a mortgage redraw or refinance.
3. Disciplined car loan repayments
If you aren’t making a significant extra mortgage payment each pay cycle, then your $30,000 car can end up costing you $77,710 like in the example above. This is the difference between a Ford Focus and an Alfa Romeo Giulia, and I know which I’d rather drive.
Set up an automated payment each pay cycle, and put a little extra in when you can afford it to ensure that you don’t lose the game of compounding interest.
Paying a bit extra will make the low mortgage interest rates work in your favour. Plus, it’ll demonstrate clearly that you have strong financial discipline, setting you up for greater financial potential in the future.
4. Comparing your car loan options
Rolling your car loan into your mortgage is not a decision to be taken lightly. When you are taking out a second or third loan, it seems like it’ll be easier to roll it all into your mortgage.
Before you take this step, make sure you know what your car loan options are, and do some calculations to work out which finance option is going to work out best for you, not just right now, but 20 or 30 years from now too.
Make sure to study your options and compare car loans to find one that suits your finances. To get in touch with our car loan experts, you can contact us or get a quick quote first.
