Car loans and the total cost

In short

A friend of mine once told me he could afford any car so long as the monthly payment fit his budget. He got the payment he wanted. He also got a loan that ran for six years. Look at the total before you sign anything. The monthly payment is only one slice of what you will pay. Ask the lender for the annual percentage rate, the length of the loan, and every fee, and then multiply the payment by the number of months. If the total surprises you, a shorter loan or a bigger down payment may be worth a talk with your family. When you shop for the loan before you shop for the car, a rate you find on your own gives you something to compare against.

The whole of it

What it is

I once watched a neighbor sign a stack of papers at a dealership with a smile on his face. The salesman had asked one question: what monthly payment do you want? That is a fine question, but it hides the bigger one. A car loan is money you borrow to buy a vehicle, and you pay it back in monthly pieces with extra charged on top. That extra is called interest. It is the price of using someone else's money.

You have probably heard the phrase total cost of the loan. It means every dollar you will hand over from the first payment to the last, plus whatever you paid up front. The car has a sticker price. The loan has its own price on top of that. Add the two together and you see what the car really costs you.

A friend once asked me how the interest on her loan was figured. Many auto loans use what lenders call simple interest. Interest is figured on the balance you still owe, so it is largest in the first months and shrinks as you pay down. Your loan papers will say which method your lender uses, so ask. It matters a great deal if you ever want to pay the loan off early.

How it works

If you are holding a loan offer right now, here is what sits inside it. There is the amount financed, which is the price of the car plus taxes and fees, minus your down payment and any trade in value. There is the rate. There is the term, which is the number of months the lender gives you to pay. Those three things set your monthly payment.

The lender must show you the annual percentage rate, often called the APR. This is the yearly cost of the loan shown as a percent, and it includes certain fees along with the interest. It gives you a fair way to compare one offer with another. The federal Truth in Lending Act requires lenders to disclose the APR, the finance charge, the amount financed, and the total of payments. The Consumer Financial Protection Bureau explains these disclosures on its website, and it is worth a few minutes of your time.

Here is the part that catches folks. A longer term makes the monthly payment smaller. That feels like a gift. It is more like a trade. You pay less each month, but you pay for more months, and interest keeps running the whole time. A longer loan also keeps you owing money for years, while the car loses value. That can leave you owing more than the car is worth. Lenders call that being upside down, or having negative equity.

Some lenders add extras to the loan, such as an extended warranty or gap coverage. These get rolled into the amount financed, so you pay interest on them too. Some may be worth having. Ask what each one costs, and ask whether you can say no.

The numbers, and where to find yours

Your credit score shapes the rate you are offered. The Federal Trade Commission tells you that you can get a free copy of your credit report from each of the three big credit bureaus through AnnualCreditReport.com. Check yours before you go shopping. An error on that report could cost you real money, and fixing it costs nothing.

Your rate is on the loan offer, labeled APR. Your term is listed in months. Your total of payments appears in the Truth in Lending box on your loan papers. If you do not see that box, ask for it. You are entitled to it.

You may also want to know what you will pay in sales tax and title fees, since these get added to the amount you finance. Ask the dealer to list each one on the buyer's order. Then compare those lines with what your state's motor vehicle agency and tax office publish, if they post them. Some states also cap the interest a lender may charge on certain loans. Your state attorney general or banking regulator can tell you what applies where you live.

If a credit union or bank will pre approve you, you will see their rate before you set foot on the lot. The Consumer Financial Protection Bureau has plain guidance on getting a loan before you visit a dealer. That gives you a number to hold up against the dealer's offer. No more guessing.

A worked example

Let me tell you about a woman named Marisol. She works as a dental assistant, and she found a used car for 20,000 dollars. She had 2,000 dollars saved for a down payment, so she needed to finance 18,000 dollars. To keep the math simple, we will ignore taxes and fees.

The dealer offered her a 72 month loan at an APR of 9 percent. On that loan, her monthly payment came to about 324.46 dollars. The dealer was pleased to show her that number. It fit her budget. She was ready to sign.

Now look at the total. Multiply 324.46 dollars by 72 months. That gives 23,361.12 dollars in payments. Subtract the 18,000 dollars she borrowed. The difference is 5,361.12 dollars in interest. Add her 2,000 dollar down payment, and the car cost her 25,361.12 dollars in all. That is 5,361.12 dollars more than the sticker price of 20,000 dollars.

Marisol asked a fair question. What if I take 48 months instead? At the same 9 percent, the payment rises to about 447.93 dollars. Multiply that by 48 months and you get 21,500.64 dollars. Subtract 18,000 dollars borrowed, and the interest is 3,500.64 dollars. She would save 1,860.48 dollars in interest, and she would own the car outright two years sooner.

That is not the whole story, and Marisol knew it. The higher payment was 123.47 dollars more each month. She had to ask whether her budget could carry it without strain. She talked it over with her sister, then called her credit union. They offered her 6.5 percent on 48 months. At that rate the payment came to about 426.83 dollars, and the total of payments was about 20,487.84 dollars, which is 2,487.84 dollars in interest. Her rate came down because she went looking. She had held a number in her hand before she walked into the dealership.

Where it goes wrong

Nobody sets out to overpay. It happens quietly. The most common slip is looking only at the monthly payment. A dealer can hit almost any payment you name by stretching the term. The payment looks the same and the total climbs.

Another trap is rolling an old loan into a new one. If you still owe more on your trade in than it is worth, that gap can be added to the new loan. You then pay interest on money for a car you no longer own. It is easy to do and hard to undo.

Watch the add ons too. A small charge folded into the loan feels like nothing. Financed for six years with interest, it costs more than the sticker says. Ask for every product to be priced on its own line, and ask whether it can be bought elsewhere for less.

Be careful with the phrase zero percent. Some offers are real. Sometimes, though, taking the zero percent loan means giving up a cash rebate, and the rebate can be worth more. Do the math both ways with the actual figures before you choose.

Last, do not let hurry decide for you. A finance office can feel like a place where every minute costs something. Take the papers home if you need to. A good deal will still be a good deal tomorrow. Slow down.

Questions to answer before you leave this page

Do you know the total of payments on the loan you are considering, and not just the monthly amount? Have you asked a bank or credit union what rate they would offer you before you spoke with the dealer? What is the APR, and what is the term in months? Could you handle a payment a little higher if it meant a shorter loan, and what would that change in your yearly budget? Are any add ons folded into the amount financed, and do you want each one? Do you owe more on your current car than it is worth, and is that gap being carried into the new loan? Have you checked your credit report for mistakes, and did you use the free copy offered at AnnualCreditReport.com? When you multiply the payment by the months, does the number still feel right to you?