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Financing a Car Purchase

In this topic, we cover:

  • How both interest rates and the length of an auto loan affect overall cost.
  • How lower monthly payments could actually be much more expensive when all costs are included.
  • How buying even a slightly used car can offer substantial savings.

Desktop showing two people holding pens and reviewing papers.

After you’ve researched vehicles and found the best option for you, there’s one more thing – how will you pay for it? In a perfect world, you’d pay in cash - eliminating the cost of financing. But with the average new car price approaching $40,000, that’s not an option for most people. 

When financing a car, there are two main factors – the interest rate of the loan and the term of your financing.

Obviously, lower interest rate loans are less expensive than higher interest rates loans, but what interest rate should you pay? Your interest rate is determined by a variety of factors, including your credit score and choice of lender. And while many car dealerships offer car financing, their interest rates may be considerably higher than banks or credit unions. In general, it's best to obtain financing approval before shopping for your car.

Understanding Total Loan Cost 
An often overlooked factor is the term of the loan – that is, how long it takes to pay it off. Auto loan terms are generally between three and seven years. The shorter the term, the lower the cost. For example, if you finance a $40,000 car at 7% over three years, your total interest cost would be around $4,400. Financing over seven years would cost approximately $10,700 – that’s more than twice as much. 

So why would anyone ever choose the more expensive loan? The monthly payment of the three year loan is higher – much higher. Longer terms help you “afford” a more expensive car, but the total cost is higher and you’ll be making payments for years longer.

Monthly Payment Options
In our example, the payment for the three-year loan was over $1,200 per month. But what if you could only afford to pay $600? One option would be to finance less over a shorter term. For example, a three year loan with a $600 monthly payment would cover a debt of around $20,000 – which is the approximate value of the same $40,000 car after four years. 

A well maintained used car can still look great and be dependable, buy you’d only pay $2,200 in interest and the loan would be paid off in three years rather than seven. You’d also save in sales taxes and depreciation, though your repair costs may be higher if the car’s factory warranty has expired. Used cars aren’t for everyone, but they’re a proven way to save.

Not sure how much you should spend on a car payment? A common rule of thumb is that your total car expense, including payment, gas, insurance – everything – be no more than 15-20% of your monthly take home pay. The lower, the better.