Most people don’t have the funds to drop several thousand dollars all at once on a new vehicle, that’s where car loans come in.

However, taking out a car loan typically comes with a price, known as interest. While the loan is a useful tool, and oftentimes a must for the prospective car buyer, you need to able to calculate your costs – both overall and monthly – and assess if it is realistic for your budget. Don’t sign any papers until you do the math. The idea of driving a new car (whether that “new” car is used or actually new) is tempting, but it’s also easy to get in over your head if you don’t do the math.

Interest Types

There are two different types of interest: simple and compound.

  • Simple interest is calculated on the principal or overall amount owed on the loan.
  • Compound interest is more complex and factors in the accumulated interest on the loan as well as the principle, which can make a huge difference in the amount of debt gained over time.

Luckily, most car loans use simple interest instead of compound, making loan payment calculations much easier.

Don’t forget about Amortization

Many loans, such as a home loan, utilize a principle known as amortization.

“ As you begin to pay the loan off, the amount of your monthly payment that goes towards the principal increases. ”

Basically, amortization means a large portion of your monthly payment goes towards the interest instead of the principal, at least at first. As time goes on, and you begin to pay the loan off, the amount of your monthly payment that goes towards the principal increases, because as the principal amount reduces, so does the amount of interest accrued.

Early on in the loan period, it’s smart to make additional principal payments. This will decrease the overall amount of interest paid.

The Down Payment Matters

How much money should you put down on a car? As much as you realistically can. You don’t want to completely wipe yourself out, but a sizeable down payment can have a meaningful influence on the overall loan amount and your monthly payment. Oftentimes you hear 20 percent being the standard go-to amount, but do more if you can.

The Magic of a Car Loan Calculator

Before you take out a loan, you should use a car loan calculator. Loan calculators are easy to use and allow you to play with different scenarios before actually going in and negotiating for financing.

“ A good rule of thumb to follow when calculating your monthly payment is that it should equal no more than 20 percent of your take-home pay. ”

Playing around with a car loan calculator will help you realize how important a down payment is to your bottom line and your monthly payments. It will also help you determine what you can realistically afford before you get to try to get financing. Bankrate has a great loan calculator that will show you both the monthly payments and the amortization schedule. Generally, a good rule of thumb to follow when calculating your monthly payment is that it should equal no more than 20 percent of your take-home pay (after taxes, etc.), and that includes your car insurance premium.

Remember that a high-interest rate and a long loan period can mean you’ll end up paying a lot more overall for your car. The longer the loan period the better the interest rate is and the lower your monthly payment will be, but your overall cost will be much higher. The opposite is true of shorter loan periods, meaning you’ll pay less in the long run, but your monthly payments will be higher.

The interest rate you’ll get will depend on your own personal credit situation and the loan duration. However, According to Bankrate, average interest on a new car loan is a little over 4 percent. So, let us consider the following example:

maxima

You’ve found a 2016 Nissan Maxima for $33,000 and would like to get financing for it. After a 10 percent down payment of $3,300, the loan would be for $29,700. Below are a couple possible scenarios for financing:

Amount paid for a five-year (60 month) loan at 4.32 percent:

  • $33,076.61 Overall Cost
  • $551.27 Monthly Payment

Amount paid for a three-year (36 month) loan at 4.12 percent

  • $31,624.15 Overall Cost
  • $878.45 Monthly Payment

You can see the difference in both overall cost and monthly payments. The shorter loan period, while more expensive on a monthly basis, will save you $1,452.46 overall. Also, the car is paid off much faster. Allowing you to put that monthly payment towards other expenses a whole two years earlier, making the $327.18 more per month seem less daunting.

Still, you could choose the longer loan period, keeping your monthly payment down, and make additional principal payments. This is another way to keep the overall cost of the loan down. Also, a higher down payment would make a even bigger impact, because it will reduce the amount the loan has to be in the first place.

Determining what’s right for you can be difficult. Make sure to take the time and do the math on a car loan before jumping into any situation. Crunching the numbers beforehand will help you ensure you’ll have no problems paying off your new car.

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