Auto Financing 101
For most of us, financing is a needed bridge to owning a new car. However at the same time going through the financing process for your new car can be one of the most stressful parts of buying a new or pre-owned car. Making a mistake with the financing can cost you thousands over the life of the loan if you’re not careful, so just as in the other areas of buying a car, make sure to do your homework! If you go in armed with the tools found on this site and others, financing doesn’t have to be stressful.
Benefits of Financing a New Car
- The primary benefit for financing a new car or pretty obvious I suppose. The benefit is that financing makes a car that would otherwise be un-affordable something that fits within your budget via monthly payments.
- Financing allows you to leverage your cash (assuming low interest rates) so you can invest cash in the bank at a higher rate in order better use your money
- Financing a new car also benefits your credit, as a paid-off auto loan is second only to a home mortgage in positively affecting your credit rating.
Drawbacks to Financing a new Car
- As opposed to paying cash, financing costs you more money. A $30,000 loan at 4.9% interest can cost almost $4000 in interest charges (Calculations via Bankrate.com)
- Financing a new car makes it less financially possible to get into a newer car in a short time
- Sales tax (where applicable) is added into the financed amount, meaning you’re paying tax and then paying interest on that tax
- Getting affordable monthly payments can require putting a large amount of down payment, or accepting longer financing terms, reducing your flexibility and costing more money in interest charges.
How does Auto Financing Work?
I’ll often have customers calculate the finance charges by taking the amount financed(x) multiplied by the interest rate(y) and then dividing the result by the term of the auto loan (X x Y)/term. However its not that easy, or that inexpensive unfortunately. The loans are amortized off the term of the loan.
In lending, amortization is the distribution of payment into multiple cash flow installments, as determined by an amortization schedule. Unlike other repayment models, each repayment installment consists of both principal and interest. – Google (thank you Google)
This means you’re paying interest based on a monthly tabulation of your remaining loan balance. The best way to see this is via a loan calculator if you’re not a whiz on a financial calculator. Using our example of a $30,000 loan at 4.9% interest over 5 years, the payment amounts are $566 per month, the first month with $441.25 going towards principle (the actual loan) and $124.75 being interest charges. The second payment would consist of $443.08 in principle and $122.92 in interest charges. You can see how the trend will go, gradually increasing the amount of principle, and decreasing the amount paid toward interest. The final payment would be $563.66 in principle, with only $2.34 in interest! See the details here
You notice the interest is weighted towards the front of the loan, not divided evenly. This means the bank gets their money up front, smart right? There’s no way to beat this system other than to pay cash, lease, or just make sure to have outstanding credit so the banks can only justify charging you minimal interest. This example comes out to just under $4000 in interest charges, but if you had the same loan amount and only qualified for 10% interest, that amount skyrockets to over $8,200 in interest!
Contact me for help with financing on your next new or pre-owned car!