We all wish we could own our dream car. But if your bank account is anything like mine, it will always be just a dream. Which means that before you go auto shopping, you must figure out how large of an auto loan you can actually afford.
Luckily, deciding which auto loans you can afford is easy. The two things you should consider are the down payment and the auto loan's monthly payment.
Auto Loans and Down Payments When you buy a car, you are expected to pay a down payment, which is the portion of the car's total payment that is not paid for with your auto loan. Basically, the down payment is what you will have to pay upfront when you buy the car. Typically, you will be asked to pay at least 10% of the car's price (Edgerton 61). For example, if you wanted to buy a $20,000 car, then a 10% down payment for that car would be $2,000. While a 10% down payment is what you are expected to pay, most financial advisers will tell you to put down a 20% down payment (Nerad 128). Which means instead of paying a $2,000 down payment for that $20,000 car, you should put down a $4,000 down payment.
Paying a larger down payment is always smart because it costs less money. Your down payment goes straight to reducing your principal, which is the amount you must repay on your auto loan. Your lender will charge interest on your principal, which means the smaller your principal, the less interest you will be charged.
Affording a larger down payment may be difficult because you will be expected to pay your down payment either out of cash, through a trade-in or both (Nerad 128). However, it is worth it because you will save money. So before searching for cars and auto loans, make sure you know how much of a down payment you can actually afford.
Monthly Payments on Auto Loans Most car buyers are enticed by low monthly payments. They see them as a way to afford their dream car. But trust me, low monthly payments are a type of low-hanging fruit that you don't want to fall for.
Lenders and dealers create low monthly payments on auto loans by spreading your loan over a longer-term length. The term length on the loan is how long it takes for you to fully repay your loan. So when you are shown auto loans with low monthly payments, your lender or car dealer is offering you auto loans that will take many years to repay.
The danger of choosing auto loans with low monthly payments is that you may end up "upside-down," which means the amount you still owe on your auto loan is more than how much your car is actually worth (Boyett 131). That happens because cars lose their value fairly rapidly. When you choose a longer-term auto loan, your car loses its value faster than you repay the loan. For example, you may still owe $10,000 on your auto loan, but your car is only worth $6,000.
When that happens, you won't be able to trade-in your car for money. Instead, after trading in your car, you will still owe money. So if you decide to get an auto loan with a low monthly payment, then you must be willing to keep the car until you pay off your auto loan or have enough money to pay for both the down payment on a new car and the outstanding balance on your old auto loan.
Your trade-in value isn't all you have to worry about when you go "upside-down." You also have to worry about getting into wrecks. If you accidentally total your car, what the insurance company gives you may not cover your total loan expenses (Howard 8). That happens because the insurance company will only give you what you car is worth. Because your car is worth less than what you still owe on your auto loan, you will be responsible for paying the difference.
As you can see, low monthly payment auto loans aren't as good as they sound. When looking for auto loans, you should only consider ones for 48-months or less (Howard 8). Now, I know you are still looking at those longer-term loans with low monthly payments and thinking that they still look nice. But there are two big incentives to getting a shorter-term loan.
The first is that you will pay less interest overall by getting the shortest-term auto loan you can afford. That's because monthly payments on shorter-term auto loans contains more principal than the monthly payments on longer-term auto loans. Reducing your principal is important because that is the amount of money that lenders charge interest on. The quicker you reduce your principal, the less interest you will be charge and the less money overall you will have to pay. If you don't believe me, let's look at the difference between 1-year auto and 5-year auto loan for a $20,000 with an 8% interest rate. For both auto loans you will have to pay the same amount of principal, which is $20,000. But for the 2-year auto loan you will only have to pay a total of $1,709.10 in interest; whereas, for the 5-year auto loan you will have to pay $4,331.67 in interest ("Monthly Auto Loan Payment Calculator"). That means the car only costs $21,709.10 with a 1-year auto loan and $24,331.67 with the 5-year auto loan. Now that's a big difference.
In addition to costing less overall, sometimes shorter-term auto loans have lower interest rates than longer-term auto loans (Cox 39). If you are lucky, the interest rate on the shorter-term auto loan will be low enough to make the monthly payment almost the same as that of the longer-term auto loan. But to find a deal like that, you must shop around. Check numerous different lenders and compare their rates. And remember, if you can't swing the payments on auto loans with term lengths of 48 months or less, then you can't afford the car. Instead you should start looking for auto loans on a less expensive car.
So here's the bottom line when it comes to deciding which auto loans you can afford. First, check to make sure you can afford at least a 10% to 20% down payment. A 20% down payment is much better than a 10% down payment. Then, look at monthly payments. When it comes to monthly payments, get the shortest-term you can afford. Only look at auto loans with a term length of 48 months or less. The incentive of getting a shorter-term auto loan is that you save money by paying less interest and sometimes your interest rate will be lower than the interest rate on longer-term auto loans.
The Rest of Our Auto Loan Guide: