Take a lower interest 9-year car loan, put the rest in FD, but settle early? No, it doesn't work that way, here's why

• You don't save money when you make an early settlement on your fixed rate car loan, even though there are rebates
• CCOB is proposing for Rule of 78 - the most common method used by local banks in calculating interest charges - to be made illegal
• Effective Interest Rate - the actual interest you pay - is hidden within the contract, CCOB wants this to be disclosed to borrowers up front.

Everyone wants better things in life, and banks love it when consumers stretch the limits of their credit. When it comes to cars, 9-year long car loans (hire purchase) are very common, dealers of regular mainstream brands say 9-year loans make up between 70 to 90 percent of all loan applications submitted.

On a very superficial level, it may seem OK to take a 9-year long car loan as monthly repayments will be lower, thus allowing you to stretch your money more every month.

Some will go to the extent of rationalising that it is better to take a 9-year loan, which sometimes have a lower interest rate than a shorter 5-year loan, as they will have more cash to put aside for investments, or even a Fixed Deposit (FD).

This is a wrong understanding and reflects poor awareness of how banks and finance work. Not all interest rates are directly comparable and the 2.8% interest rate you pay on your traditional fixed rate car loan is not the same 3% you read on brochures of savings products like FD.

The method of calculation is completely different.

Others say that it is better to take a longer 9-year loan with lower monthly instalments, and then make an early settlement to save on interests.

That is partially true because there will be some rebates if you make an early settlement, but know that banks have thought everything through and there are very few scenarios where you can outsmart the bank.

The bank always has the upper hand and one of their most successful marketing efforts is to make borrowers think that they can save some money by taking a longer 9-year loan but make an early settlement.

Before deciding if you should take a 9-year loan, there are three aspects that borrowers should know about:

• Difference between fixed rate- and variable rate-type hire purchase – the two main types of car loans available
• Rule of 78 – how borrowers will always get the short-end of the stick when an making early settlement
• Effective interest rate – the actual cost of your financing

Fixed rate vs variable rate car loans

Fixed rate products are the traditional car loan that dealers will pitch to buyers. Its calculation method is the easiest to understand, and buyers will only have to remember to pay the same fixed amount every month.

There is no benefit in paying more each month, and even if you are to make an early settlement, the savings in interest is not as straightforward. More on that later.

Variable rate products are less common. Few buyers understand it and car dealers don’t promote it to buyers unless they are asked to.

Variable rate products means that the monthly repayment may vary from one month to another, depending on how much you have paid so far, and the bank’s prevailing base rate (BR), itself based on Bank Negara’s Overnight Policy Rate (OPR).

With variable rate car loans, sometimes you may pay more than traditional fixed rate loans, other times you may pay less.

If you have extra cash, you can also pay more than the given monthly instalment amount. The faster you clear the balance, the less you pay in the following months.

Interest charges are calculated based using the reducing balance method, on the loan's remaining balance, similar to home loans. Thus, total interest charges may be lower as the sum that interest charges are calculated on will only keep getting lower every month as you make more payments.

Meanwhile with traditional fixed rate products, interest is calculated on the borrowed amount, which won’t change, thus interest charges can be very high (all else being equal, when compared to variable rate products).

But you cannot compare interest rates of fixed rate products with variable rate ones, because the methods of calculation are different. To compare them, you need to convert the interest rates into what's known as EIR, or effective interest rate, more on that later.

Despite the above, one still cannot say that variable rate products are better than fixed rate products. Like all financial products, what is good or bad is highly dependent on your individual needs, income, commitments, and financial goals.

Rule of 78 – how banks fool you into thinking you are saving money by making an early settlement

The saying “The house always wins” also applies to relationship between banks and their customers.

Remember we’ve said that monthly instalments for variable rate products is calculated on the remaining balance while fixed rate ones are calculated on the borrowed amount. Rule of 78 is the calculation method used by the latter.

Without going into too much details, Rule of 78 ensures that the bank gets paid first, and your debt is paid last.

Right from the start, Rule of 78 keeps the bank on the winning side, regardless of whether you choose to choose to pay off your 9-year loan (108 months) on the final 108th month or earlier. This is done by cleverly hiding your monthly instalment’s split between interest charges vs borrowed sum.

So even though the amount you pay every month is the same, the first 3 years of your monthly repayments for a 9-year loan are spent paying the interest – the bank’s profit from lending you money to buy a car you can’t afford. The debt from the sum you borrowed stays mostly unchanged until much later.

Only in the second half of the loan’s tenure, when the bank has already made most of its profit, will you start clearing the debt from the borrowed sum.

Refer to the table below, note that a 9-year loan that is settled early after the third year sees very little savings.

• Loan amount: RM 100,000
• Interest rate: 2.8% for 9 years
• Interest: RM 25,200
• Total debt to pay: RM 125,200

The total interest charges for a RM 100,000 loan on a 2.8 percent interest rate is RM 25,200, but the borrower who makes an early settlement on the fifth year gets less than RM 5,000 in rebates on interest charges, or one-fifth of the total interest, even though he is paying off his loan nearly 50% faster.

This is because Rule of 78 ensures that the bank has already earned its profit well before the borrower makes an early settlement.

If you plan to save on interest charges by making an early settlement on a 9-year loan, you need to do it within the third year. The potential rebates diminishes rapidly once you enter the fourth year.

Rule of 78 is illegal in many countries, including UK, Australia, New Zealand. Even in the USA, the world’s capital of capitalism, banks are only allowed to use Rule of 78 for loans no longer than 5 years.

The Consumer Credit Oversight Board Task Force (CCOB) has proposed for Rule 78 to be abolished but Bank Negara has yet to make any decision on the matter.

Also read: Unfair car loan practices - Malaysian financial taskforce proposes Rule of 78 method to be made illegal

Effective interest rate - the real cost of borrowing that banks hide from you

The 2.8 percent interest rate quoted by the bank offering you a fixed rate loan for your car is never actually 2.8 percent.

In every car loan agreement, two interest rates are quoted. The first is the one communicated to the borrower, the second is the Effective Interest Rate – the real interest rate, which banks hide it within the contract.

Remember that interest rates for fixed rate products are calculated differently? To compare with other financial products, you need to convert the car loan’s interest rate into Effective Interest Rate, or EIR.

Typically, the Effective Interest Rate is slightly less than 2x higher than the one used by fixed rate products.

As you can see from the examples above, the actual interest rate is a lot higher than what you can earn if you put your extra cash in a zero-risk Fixed Deposit, so no, it doesn’t work that way.

CCOB is also proposing for EIR to be disclosed to the borrower before contract signing stage, along with the proposal to make Rule of 78 illegal.

Conclusion – understand your car needs, set your own financial goals

This post is in no way saying that variable rate products are better than fixed rate products, because just like there is no one perfect car for two different buyers, there is no one-size fits all financing solution for everyone.

If you have to take a 9-year loan, you need to understand what you are getting into, and that the car may depreciate faster than you can clear a 9-year loan.

This is how many buyers are trapped in their existing car loans because the market value of their car is less than their loan’s outstanding balance. To sell their car, they need to cough up more money to pay off the loan because the Rule of 78 is working against them.

You may think that this is not a problem if you buy a high resale value Perodua Myvi, Honda City, or Toyota Vios, and you intend to keep your car for 10 years.

But sometimes life don’t go as planned. Your car could be severely damaged in an accident or flood and your insurance may not agree to a total loss. Depending on your insurance's contract on betterment fee, if your car is older than 5 years old your insurance can force you to accept cheaper OEM parts instead of original parts. You car is never going to be same again and you have no choice but to continue paying for it.

Or your car may develop a major problem after the car’s 5-year warranty has expired, and you may not want to keep paying for such a car anymore.

The first step in making the right decision is to ask yourself what your financial goals are, and what do you need from a car. Only then can you decide which is the best financing option, and which is the best car for you.