When you are shopping for a car loan, you need a payment that you will be comfortable with for the long term. However, the lowest payment may not necessarily be your best option. Many people make the mistake of obtaining car loan financing for a longer period of time just to lower the payment. There can be several drawbacks to this type of financing.
As a general rule, you should finance your car loan for the shortest amount of time possible. Many recommend you finance for 48 months and never any longer than 60 months. While many dealers will allow you to finance for 72 months or longer, this is not a financially wise decision.
The longer you finance, the more you pay
For each month you extend your car loan, you pay more in interest. To ensure the lowest amount of interest, you should finance for the shortest amount of time. In addition to paying more interest because the term is longer, the interest rate also increases with each year you add to the loan.
To see the difference in your total payback for a car loan, let's look at the following example, which assumes your car loan is $25,000.
| ||48 months ||60 months ||72 months |
|Payment ||$585 ||$485 ||$420 |
|Interest rate ||5.9% ||6.2% ||6.5% |
|Total Interest paid ||$3,127 ||$4,138 ||$5,257 |
As you can see, the longer you finance your car, the more in interest you will pay.
You increase your risk for an upside down auto loan
An upside down car loan is when you owe more on the car than it is worth. This can amount to a lot of money out of pocket if you decide to sell the car or if you are in an accident and the car is totaled. It is important to avoid this situation if possible.
A new car generally loses 15-20% of its value as soon as it is driven off the dealer's lot. Unless you put down a sizeable down payment, you could be in an upside down auto loan from the very first day. The best way to avoid this is by having a down payment of at least 20%. In addition to a down payment, you also need to finance your car loan for the shortest term possible. These two tactics combined will result in the lowest risk for an upside down car loan.
Let's assume the above given example again and see what happens in relation to the car value and the loan amount over the life of the loan. This assumes a $25,000 SUV with no down payment.
| ||Loan Balance |
|Type of car ||Car value ||48 mth. loan ||60 mth. loan ||72 mth. loan |
|End of 12 mth. ||$18,325 ||$19,779 ||$20,975 ||$21,780 |
|End of 24 mth. ||15,475 ||13,753 ||16,317 ||18,043 |
|End of 36 mth. ||12,150 ||7,361 ||11,362 ||14,055 |
|End of 48 mth. ||10,175 ||0 ||6,090 ||9,801 |
|End of 60 mth. ||8,275 ||N/A ||0 ||5,251 |
|End of 72 mth. ||7,100 ||N/A ||N/A ||0 |
Of course, this is only an example as different cars hold onto their value more than others. In this example, you can see that you will be upside down in the car loan with a 72-month loan for the first three years and most likely still would be if you sold the car after four years because of the values being so close. In this example, even with a 60-month car loan, you would be upside down until the end of year three. This also assumes that you sold the car privately. If you looked at the same scenario with trade-in values, it would show an even worse situation.
As you can see from these examples, the lowest payment on your auto loan doesn't always equal the best decision. You should always look at other factors including the amount of interest you will pay over the life of the loan as well as how quickly your vehicle will depreciate. An easy way to do this is to look at the difference in price between the used and new vehicle of your choice. While all cars depreciate, some will hold their value better than others, which can make a big difference financially if you decide to sell before you pay off your car loan.
Be sure you can comfortably afford your car payment. Do not stretch yourself in making payments just so you can avoid extra interest payments. While it is important to try to avoid an upside down car loan and save yourself money if possible, it is more important to keep your credit rating in tact. If you can only afford your car by stretching the auto loan out for more than sixty months, it may be an indication that you need to look for a less expensive vehicle.