Buying a Car: What Term Should Your Loan Be?
If you're thinking about buying a car, you're probably thinking about financing. You may be trying to choose the right bank, get the lowest interest rate or find a good monthly payment. Another important consideration to make is how long you plan on paying off your car (also known as your loan term). We've outlined a few factors to help you decide which loan term is right for you.
Before we consider which term is right, it's probably best to think about which terms are available. In general, car loans are structured to offer 12-month increments and last somewhere between two and eight years. That means you'll find available loans of 24 months, 36 months, 48 months, 60 months, 72 months and 84 months. The average new car loan is around 65 months, or more than five-and-a-half years, while the average used car loan is shorter.
When you're signing the paperwork at the dealer, you'll be tempted to go for a longer term. There's a reason for that: By stretching out the payments over a longer period of time, they become lower. Initially, that might seem like it's more cash in your pocket, and that's a good thing, right?
The problem with long-term loans is that they come with increased interest, which in other words is the extra money you have to pay the bank for giving you the loan. So while a lower monthly payment might seem like it's benefiting you, it's usually a worse decision.
As an example, consider a 36-month car loan on a $28,000 vehicle. With a 3 percent interest rate, the monthly payment is more than $810 -- not a small figure. But the total amount paid over the life of the loan is $29,160, which means the loan only costs the borrower $1,160.
Meanwhile, consider the same $28,000 vehicle with a 72-month loan where the interest rate has now doubled to 6 percent. By making the loan longer, the payment drops drastically to just $464 per month. But now the total amount paid is a whopping $33,408, meaning that the $28,000 car costs thousands of dollars extra when financing over the longer term with the higher interest rate.
So why not go for a short-term loan and take advantage of a lower rate? The main problem is the monthly payment. After all, it's no fun to make luxury-car-like monthly payments on a typical car such as a Honda Accord or Toyota Camry, even if you know in your mind that it's the smartest financial decision. Instead, most shoppers would rather finance over a longer term, even if it means paying more in the end, to get the payment to an affordable level.
Our Advice: Think Long-Term With a Short-Term Loan
In the end, our advice is simple: When you're buying a car and considering a car loan, opt for the shortest term and the best possible interest rate. In the short term, this might not be the most appealing idea, considering it will increase your monthly payments, and it may limit the type of car that you can afford. But in the long term, you'll thank yourself when you've saved thousands in interest and paid off your car years before you thought you would.