Once you've determined the car or truck that will meet your needs, financing is the final factor to consider. Ideally, you can purchase the vehicle with cash, eliminating financing costs. But if that's not an option, you'll want to consider both the interest rate of your loan and the term of your financing.
About Interest Rates
Lower interest rate loans are less expensive than higher interest rates loans, but what interest rate should you pay? Various factors, including your credit rating and choice of lender, determine your interest rate. While many car dealerships offer car financing, and some may offer competitive rates, obtaining financing approval from a bank or credit union before shopping for your car is best. That way, you'll have a reality check to compare against any dealer options.
When shopping for a loan, get a few competing quotes on a car loan – interest rates can vary considerably between financial institutions. However, be aware that several credit inquiries may affect your credit score, especially if you have multiple inquiries within a short period. You can also check websites such as Bankrate.com to see what auto loan averages are.
If you have little credit history or a history of credit problems, you may receive a lower interest rate if you have a cosigner on the loan. A cosigner with established credit would be responsible for making the car payment if you did not.
The Loan Term
The loan's term (or length) is an often-overlooked factor when financing a car. Car loans are generally between three and five 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 the three-year loan.
So why would anyone ever choose the more expensive option? The monthly payment of the three-year loan is $520, and the monthly payment of the longer-term loan is $317. So, 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.
Most experts suggest limiting the car loan term to 60 months or less. Otherwise, chances are good that the loan could become an "underwater" loan, meaning you owe more on the car than it's worth.
Loan Affordability
Let's look at the purchase from another perspective, the perspective most people consider when making a significant 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?
In that case, you have a couple of options – you could 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. However, financing 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 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 loan term. A common rule is that your total car expense (payment plus other expenses) should be no more than 15-20% of your monthly take-home pay – the lower, the better.
