Auto Loans 101: Understanding Your Financing Options

Purchasing a car involves more than just selecting the right model or negotiating the sticker price; it's also important to understand how financing choices impact the total amount you'll pay over time.

When you’re shopping for a car loan, remember that the total cost of borrowing depends on three key factors:

• The finance charge, expressed as an annual percentage rate (APR)
• The term, or the length of time it takes to repay the loan
• The principal, or amount you borrow

The APR

The Annual Percentage Rate (APR) is the yearly cost of borrowing for a car loan, shown as a percentage of the loan amount. It includes interest and any fees, which are added to your loan balance and paid through monthly payments.

For example, if you take out a $15,000 loan for four years at a 7.5% APR, your monthly payment would be approximately $363, and you would pay about $2,408 in total interest, resulting in a total repayment of $17,408.

When you’re looking for a loan, aim for a lower APR, since higher rates increase the overall cost. 

The Term

The term of your loan also affects what it costs you to borrow. Shorter terms mean higher monthly payments but a lower total cost, while longer terms lower your monthly payment but come with a higher total cost.

For example, consider the differences on that $15,000 loan at a 7.5% APR from the example earlier. Monthly payments would be about $467 for three years, $363 for four years, and $301 for five years. However, interest and finance charges move in the opposite direction, rising from about $1,798 to $3,034 as the term lengthens.

You may choose a longer loan term with higher costs if it makes it easier to manage smaller monthly payments than larger ones. After all, it can be worth it to pay a little more over time if you’re worried that you might default on your payments.

But keep in mind that as your car ages or if you drive it extensively, maintenance costs may rise. Avoid selecting a loan term that keeps you paying while also facing significant repair expenses.

Balloon Loans

You might hear about balloon loans as you shop around for car financing. These loans require you to pay only interest during the term, with a large final payment of the principal due at the end. While this option may seem attractive, especially if you can’t afford a down payment, it’s risky. If you can’t make that final payment, you might need to take out another loan or face having your car repossessed.

The Principal

It should come as no surprise that the more you borrow, the more you’ll pay in interest. So the more you can reduce your principal, the more affordable borrowing will be.

To reduce your overall costs, consider making the largest down payment you can afford; this will help lower your interest expenses. Additionally, seek out a car with good trade-in value and trade it in while it’s still in good condition to save money in the long run.

Not-So-Hidden Costs

Keep in mind that you should include the cost of auto insurance when deciding what car to purchase and what monthly payment you can afford. Your insurance premium will vary depending on factors such as where you live, your age, the coverage you choose, and the car you buy. Generally, a newer and more expensive car will be more expensive to insure.