Determining the cost of a loan is inherently complex. A number of factors affect the final cost of the loan. Regardless, a few simple truths exist:
In each of these cases, the cost of the loan will be higher. While the first two points are fairly intuitive, the third point catches a lot of people off-guard. A salesperson will frequently attempt to lower your monthly payment, sometimes quite substantially, by stretching out the loan period. But you need to understand that this will ultimately cost you more. For example, the monthly payment on a $15,000 loan at 8% for five years is $62 less than the same loan over a four-year period. However, the total interest expense is $672 more for the five-year loan versus the four-year loan. This is the price you pay for the privilege of stretching out your payments for one more year to make them more affordable on a monthly basis.
Finding Yourself "Upside-Down"
Nowadays, it almost seems you have to pay as much for a new car as you did a decade ago for a house. But as new-car prices rose dramatically in recent years, lenders found a clever way to allow people to continue to buy new cars: they simply extended the length of loans, thus keeping monthly payments affordable.
In the past, 24- or 36-month car loans were the norm. But today, 60- and even 72-month loans are common. With these longer loans, however, it takes longer to reach a positive equity position in a car and owe less on it than it's worth. As soon as you drive that shiny new car off the dealer's lot the car plunges in value - thanks to depreciation. But with a shorter length loan, after a year or so of making payments your car's value will be worth more than you owe on it. Until then, you're upside-down, as they say in the auto business.
With longer loans, however, you could be upside-down for two, three or even four years. It typically takes 40 to 42 months to build equity in a car if you put 20% down and have a 60-month loan. And therein lies the rub: If during that time you want to trade in your car on another one, you'll be in the frustrating situation of owing more on your old car than it's worth, thus making it all the more expensive for you to buy the newer car.
So, if you must take out a longer loan in order to lower the monthly payments on the car you really want, plan on keeping the car for nearly the life of the loan. If you can't keep it that long, be sure to choose a car that holds its resale value well because that will reduce the time it takes you to reach a positive equity position.
