In last week’s blog, How to Buy a Car: How Much Should I Spend on a Car? Part I, we discussed a couple of methods for determining how much you can afford to spend each month.
But that wasn’t the whole picture.
Focusing too much on your monthly payment is not a good idea. The only people who think it’s a good idea to decide if you can afford a car based only on the monthly payment are unscrupulous salespeople.
Getting you to tell them how much you can pay per month is their number one job, in fact.
Monthly Payment: Let’s Look at the Math
By getting you to look only at the monthly payment, they can move you toward more a more expensive car with a longer payment schedule. Over a long enough time frame, you can afford practically anything.
But the problem is that you end up paying a lot more money in the long run, probably for more car than you need. That only benefits two people: the lender and the salesperson.
You see, the longer the loan term, the more interest you pay. For a simple example, let’s say the amount you need to finance is $10,000. Here is a comparison between a 48-month car loan (which is generally a good loan term to shoot for) and a 72-month loan, using our car payment calculator:
That’s nearly $660 more you’d spend over the life of the loan!
But wait… Should both loans have the same interest rate…?
No, they shouldn’t. Lenders like longer loan terms for the money they make but they think of them as bigger risks. That means they usually charge higher interest.
Here’s the 72-month loan recalculated with a 7.00% interest rate instead of 6.00%:
The higher interest rate adds another $340 to the total cost, making your total extra expenditure just over $1,000!
And that’s just the extra cost for the longer loan term! What happens if you let the salesperson sell you on the monthly payment?
Well, you will notice in our examples, even though you spend more in the long run, your monthly car payment goes down from $235 to $170. If that salesperson knows you want to spend around $235 per month, he might try to get you into something else more expensive, to make up for the difference.
Here’s an example using our car loan calculator:
Wow, that escalated quickly!
Working backwards from a $235 monthly payment, you’re now spending $13,783 instead of the $10,000 original budget.
And suddenly, your total cost of the vehicle has jumped to $16,920 after all interest is paid. That’s $4,645 more than a $10,000 loan for 72 months, and $5,648 more than the same loan for 48 months!
What Could Go Wrong?
If that weren’t enough, there are some other considerations, too.
Not everyone knows that when you pay your car loan, the payments are structured so that you pay most of the interest in the early part of the loan. This means that the principle (the original amount you borrowed) doesn’t go down much for a while.
This is important because, if you have some bad luck and total your car before it’s paid off, the remaining balance on the loan could be higher than what the insurance company thinks your car is worth.
Because a car is a depreciating asset, meaning that it pretty much constantly loses value (with a few rare exceptions, like bona fide classic autos), the longer your loan term, the more like this will be the case.
Now, there is something called GAP insurance (we’ll cover this later) for just this occasion, but that’s another expense.
Similarly, if you need to sell your car for any reason, like needing a different type of vehicle or losing a job, you’ll have to cover that difference out of your own pocket. It’s not so hard to get shackled to a car that you can’t get out from under if you really need to.
And let’s not forget the possibility of mechanical problems. The longer you own a car, the more likely it is to have some issues. When you have a long-term loan, having major mechanical issues could mean you’re still paying on a car that you can’t even drive.
We’ve come a long way in explaining how to calculate how much you can spend on a car. There are still some variables to cover, though, and we’ll get to some of those next week when we talk about your credit, what it means, and how it affects your car payments.