Car finance explained

Financing a new car – or even a used car – is a maze of different options and potential pitfalls.

Each option (and paying cash, for that matter) has its own set of pros and cons. Usually, finance is convenient and fast. Cash takes time to save, and it's your money being spent – after you've already paid the tax on it. And as it's coming out of your own savings you won't be earning any interest on the money spent.

Finance, on the other hand, will cost you more in interest than whatever you'll earn from your cash savings. For consumers looking to buy a new car or a used car, the interest paid on a car loan or hire purchase or line of credit matters less, as long as the monthly repayment is manageable.

For truly savvy buyers, a novated lease represents the best option. If your employer and the Australian Taxation Office are both in agreement, a novated lease will save you interest, which is offset against your taxable income.

It means you're being charged less for tax, because the lease repayment is deducted from your pay before the tax is calculated. The tax break is better still if the loan repayment reduces your pay below a tax rate threshold.

Maybe you're retired, or on the sort of wage that doesn't incur much tax – or any at all even, if you're young and living at home with Mum and Dad. A personal loan, which is an 'unsecured' loan, might be right for you. That is presuming you're in an entry-level job or casual work and there'll be practically no tax advantage to be gained from pre-tax repayments (salary sacrifice).

Other options include mortgage redraw, which is convenient but can be costly in interest over the longer term. This type of borrowing is also known as 'line of credit'. Then there are yet other types of finance, such as hire purchase, which is a 'secured' loan, just like a conventional car loan.

A secured loan is any loan that requires collateral – some sort of property that can be used to guarantee you, the borrower, will not default on your loan repayments. A mortgage is a type of secured loan. In the case of car loans, the car is the 'security' – the property that can be repossessed by the lender if you default (failing to repay the loan on a regular basis).

An unsecured loan, is typically a personal loan. If you default on the personal loan, the lender may find legal means to recover the amount you owe, but the car you've purchased with that loan can't be immediately repossessed by the lender. The property purchased with the loan has to be specifically named in the loan contract as collateral for the lender to recover the amount owed through repossession.

There are any number of different institutions that can lend you money. Some of them, such as the financial services divisions of car companies, specialise in loans and leases for purchasing cars.

There are also, of course, conventional banks, plus credit unions and finance companies. Companies can be retail financiers, or they can operate through dealerships, where the 'F&I guy' is the agent selling you the finance for your new car.

As a general rule, more conservative financial counsellors suggest the total amount you spend on a car (including registration, insurance, maintenance and consumables as well as the loan repayments) should not exceed 10 per cent of your gross income. If you earn $72,000 a year before tax, your total expenditure on your car – including the loan repayment – should not exceed $600 a month.

If you spend $60 a week in fuel, plus $40 a month for maintenance, perhaps $70 a month for registration and a similar amount again for comprehensive insurance – or more, depending on the car and your driving record – you're left with $140 a month for a loan repayment.

That's not much, but it it's enough to qualify you for a $6000 personal loan, paid back through a major Australian bank over a five-year period.

If you're on the average Australian wage, which now exceeds $80,000 a year, the major Aussie banks will lend you up to $50,000 as an unsecured personal loan – provided you meet the conditions the banks stipulate. To borrow that amount will cost around $1100 per month, based again on a five-year loan period.

Your ability to service the loan (i.e.: make repayments without being stretched) will depend on your personal situation.

Do you live with your parents? Are you independent, but raising a family? Do you already have fixed financial commitments like a mortgage, for example? Maybe you're retired, or an expert player in the sharemarket. Perhaps you're a farmer, with limited income throughout the year.

All of these considerations, and others, will have some impact on your ability to service a loan. Among the other considerations, there is also the purchase price of the car, plus your gross (before tax) income, your lifestyle choices and the number of dependents. Dependents may include your spouse, children and aged parents living under your roof.

Also, check out the MONEY SMART site, a federal government initiative through ASIC (Australian Securities and Investments Commission). This site can also point you in the right direction for financial counselling if you find yourself in trouble.

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