Smaller payment or shorter term

How does financing a car work?

If you’re thinking of buying a car, you’re probably thinking about make, model, color and year. You’ve wisely done your research, and you know which features you must have and which you can do without. You’ve compared the fuel economy of various models, the cost to insure each one and the sticker price. While you’re on the subject, don’t forget to think about how you'll finance your car.

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Your auto loan has two components: the interest rate and the length of the term, or how long it will take you to pay off the loan assuming you never skip any payments or make extra payments. The term is important because, like the interest rate, it affects the size of your monthly payment. A longer term translates into a smaller payment; a shorter term translates into a larger payment.

So why doesn’t everyone take the longest term they can get? Because doing so does more than just lower your monthly payment, it also increases the overall cost of the loan. Each month, when you make your car payment, you are paying some principal and some interest. The total amount you pay for the car is the sum of all the principal and all the interest. The principal remains the same no matter how long the loan term, but the amount of interest you pay will increase as the term of your loan grows longer.

One way dealers negotiate with buyers is by adjusting the length of the loan term. This is neither good nor bad; for many people this is the best way to make a reliable vehicle affordable. If you find yourself engaged in this negotiation, remember that it is in your best interests to keep the term of your loan as short as you can comfortably afford.

To make the best deal possible, get pre-approved for an auto loan before you go car shopping. You and your lender can calculate how large a payment you can comfortably afford each month and set a loan term that fits within those parameters. With that information in hand, you can drive your best bargain at the car lot.

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