Car loans have three core pieces: The principal, or how much you’re borrowing; the interest rate, or how much more you’ll pay on top of the principal to purchase auto financing; and the term, which is how long you’ll be paying off your car. And while that last part may seem simple, in truth how long you take to pay off your car can have an enormous effect on your finances.
Why Is My Car Loan Term Important?
Many of us think of the car loan term as just dates on a calendar, but it actually makes more sense to think of it as slices of a pie. If, for example, you sign onto a car loan with a 48 month term, you’ll be dividing your car loan into 48 total payments and, at the end of it, you’ll own a car. This is why the longer a term on your loan, the lower your monthly payment; you’re paying off a smaller slice of that financial pie.
But it has an important impact elsewhere in your loan; the interest rate. The higher the number of payments you make on a car loan, that is, the longer you take to pay it off, the longer that interest rate you agreed too remains in effect. Furthermore, the longer you take to pay off your loan, the more of the principal remains for you to be charged interest on. Depending on your interest rate, you might be spending hundreds of dollars more on your car than you otherwise might.
Finally, it sets an important milestone: When you own your car free and clear. You want this to be as quickly as you can afford it, for a few reasons, but the most basic is that you’ll be able to sell your car for more to buy a new one. Cars lose value over time, and the longer you have to wait to trade it in, the less you’ll be able to put towards your next car for a trade-in.
With all that in mind … how do you choose the right term?
Choosing A Term
First of all, sit down with an auto loan calculator and do the math. How much more in interest will you pay if you accept a longer term? This is important not least because, well, it’s your money, and presumably you’d like to spend as little of it as you reasonably can. Knowing what it’ll cost you in interest will be important.
Secondly, look at the value of the car you’re considering now versus where that value will wind up over time. As a rule, it’s easy to forecast where a car will be in terms of value five to seven years from now, and that should be a factor as well. Pay close attention to the overall cost of your loan and the value of your car over time; if you’ll go upside-down, or owe more than the car is worth, don’t take the loan at that term.
That said, consider your budget. While you shouldn’t look only at the monthly payment, the truth is that if you can better afford a longer term, it’s something you should take into consideration. If you need a car and you’re on a tight budget, you might simply need to accept the term that makes sense in the short term.