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Car loans can be complicated. First, you need to figure out how much you can afford including insurance and other expenses and then you can pick the car that fits your price range. After you’ve picked your car, you need to calculate your down payment (usually 20% of the price of the car), before checking your credit score to see what kind of APR you qualify for.
But after all that, you’re done, right? Well, when you go to finance a car there is, of course, the final element of how long your loan term is going to be, which determines how much your monthly installments will be.
It can be tough to understand for how long your loan term should be, especially since lately car loan term lengths have gone from 48-60 months, and are steadily going up.
At first, a longer-term loan can seem attractive because the monthly payments are lower, but you must appreciate how explosive an element APR can be. It stands to reason that if you extend your loan, the interest doesn’t just go away after a while. It’ll keep going with the loan, and you’ll end up paying even more.
To avoid this, try to get as small of a loan term as possible, while still being affordable. Since interest is dependent on length and time, paying off your loan faster means paying less interest. You may hear the term “amortization” floating around, which illustrates that since interest is based on the current amount of your loan, the interest amount will be higher at the beginning since your loan is at its highest.
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Some dealerships will try to sell you on lower monthly payments, and this is a pitfall for consumers. If you choose smaller payments, what the dealership will do is tack on an extra thousand dollars to the sticker price so you end up paying more for the car. Lower monthly payments aren’t the answer for comfortably buying a car, at least not in the long term.
Building equity is an important part of car buying as well. New cars depreciate about 20% after the first year, and upwards of 60% after the first six. So for the first few years, you’ll be underwater on your car loan, which means you’ll owe more than the car is worth.
To mitigate this impact, you need to build equity as fast as possible, and that means minimizing the amount of time that the car is underwater. You can accomplish this by applying for a big down payment and having a shorter loan term.
There is a way you can avoid all of this and that is to buy used. The interest rates tend to be higher, but the car is cheaper, and if you get one that’s five or so years old you won’t be dealing with depreciation steep enough to compete with the Hoover Dam.
The point is, it’s always the best idea to pay your loan off as fast as possible. Not only will you be paying less interest, but you’ll also have the satisfaction of actually owning the car, and not having it belong to someone else while you drive it.
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