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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 substantially lower your overall costs.

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Once you have determined the car or truck that will meet your transportation needs while offering the lowest fuel, maintenance, repair, and depreciation costs, the final factor to consider is financing. Ideally, you will be able to purchase the car with cash - completely eliminating financing costs. If that is not an option, you will need to consider both the interest rate of your 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 rating and choice of lender. While many car dealerships offer car financing, their interest rates may be considerably higher than banks or credit unions. Also, if you are negotiating the purchase of a car and must reveal your maximum monthly payment to learn more about financing, you are in a less than ideal negotiating position - the dealer can simply lengthen the term of the loan to meet your payment goal while keeping the overall cost of the car high (and charging you thousands in additional interest). It's best to obtain financing approval from a bank or credit union before shopping for your car.

When shopping for a loan, get a few competing quotes on a car loan - interest rates can vary considerably between financial institutions. But be aware that credit inquiries may affect your credit score, especially if you have multiple inquiries within a short period of time. If you have little credit history or a history of credit problems, you may be able to receive a lower interest rate if you have a cosigner on the loan. A cosigner is a person with established credit who would be responsible for making the car payment if you did not.

An often overlooked factor is the term (or length) of the loan. Car loans are generally between three and six years in length - the shorter the term of financing, the lower the overall financing cost. For example, if you are financing $15,000 of a car purchase at 15% interest over three years, your total interest expense would be $3,719 over the life of the loan. Financing the same purchase at the same interest rate over six years would yield an interest expense of $7,836 - more than twice as much as the three year loan. So why would anyone ever choose the more expensive option? Cash flow - the monthly payment of the three year loan is $520. The monthly payment of the longer term loan is $317. So in order to save that $4,117 in financing charges, you would have to pay an additional $203 per month. Even though the costs are ultimately higher, financing for a longer period lets you "afford" a more expensive car.

Let's look at the purchase from another perspective, the perspective most people consider when making a major purchase - what you can buy for a maximum monthly payment. In the example above, the payment under the shorter-term loan was over $500 per month. But what if you could only afford the $317 payment? You have a couple of options - you could choose to pay more in interest and finance over a longer term or you could finance less over a shorter term. A three year loan with a $317 monthly payment limit would cover a debt of $9,000 with a total interest expense of $2,231. Whether you could find a suitable vehicle for $9,000 is a decision only you can make. But choosing to finance the lower amount over a shorter term would save over $5,500 in interest charges compared with the higher price financed over a longer term - but with the exact same monthly payment. You would also save in sales taxes and depreciation, though your repair costs may be higher.

As you can see, the total financing cost can significantly change with the term of the loan. A common rule of thumb is that your total car expense (payment plus other expenses) be no more than 15-20% of your monthly take home pay - the lower, the better.