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Buying a Car: What Term Should Your Loan Be?

As with so many things in life, deciding how long my car loan should be boils down to a cost-benefit analysis. There is the odd exception, but the main reason for financing a car rather than paying cash for it is to spread the cost over several smaller payments instead of one big one. To do so, though, means borrowing however much of the cost we need to defer. Typically, that’s 80 percent or more of the transaction price of the vehicle, depending on the amount of the down payment.

Several smaller payments are better than one big one, right? In a word, no. But for most of us, borrowing the money is the only way we can afford the car. That said, there will be a loan. The question then becomes, how many months do you want to make those payments? How much you pay for the money you borrow, or interest, is based in large part on the length of the loan. The longer the loan, the higher the interest.

How Long Can I Finance a Car?

Before considering which term is best for you, it’s probably best to think about which terms are available. In general, car loans are structured to offer 12-month increments lasting somewhere between two and eight years. Meaning, you’ll find available loans of 24, 36, 48, 60, 72, 84 and 96 months. According to the credit experts at Experian, at the end of 2019, the average new-car loan was around 70 months, or close to six years, while the average used-car loan was about four months shorter.

What Are the Disadvantages Long-Term Loans?

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 monthly 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?

Not so fast. Remember: the longer the term, the higher the rate of interest. That’s the extra money you have to pay the lender for giving you the loan. So while a lower monthly payment might seem like it’s benefiting you, it’s usually the more expensive decision.

Another long-term issue is, never really building any measureable equity in your car. That is, with those loans spanning six, seven or more years, your car won’t be worth more than you owe until close to the end of the loan. Moreover, with a seven- or eight-year loan, not only will you still be making payments at the loan’s end, but you will also be paying to make repairs to the car.

What Is the Disadvantage of Short-Term Loans?

So why not go for a short-term loan and take advantage of a lower rate? For most of us, the main problem is the size of that short-term monthly payment. After all, it’s no fun making luxury-car-like monthly payments on a nonluxury car, such as a Honda Accord or Toyota Camry, even if you know in your mind that it’s the smarter financial decision. We all are limited by a monthly budget and often have no choice, but to spread out the cost of a vehicle. With that in mind, Autotrader always advises against buying more car than you can afford.

How Does the Interest Rate Impact a Car Loan?

Beyond the length of a loan, other factors, such as credit history, can affect your actual interest rate. For our puposes, though, we will use current average rates as posted by valuepenguin.com. Here’s an example of the difference in the interest cost of a short-term versus a long-term loan.

Let’s say after a down payment, taxes, fees and so forth, the final amount to be financed is $25,000. A 36-month loan has an average interest rate of 4.21 percent. With a monthly payment of $463, the total cost of the loan would be $27,767. A 72-month loan on the same amount with an average interest rate of 4.45 percent works out to a monthly payment of $397. The total cost of that loan would be $28,532. Stretching that 36-month loan for an extra three years would wind up costing you $765. 

Is a Short-Term or Long-Term Loan Better?

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.

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Editor’s Note: This article has been updated for accuracy since it was originally published.

 

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