Buying a new car can be a stressful experience, especially if it involves financing. Many buyers rush into the process unprepared, which can end up adding to the cost of the transaction. Here are a few factors to consider when looking at a car loan.
First, shorter is better. This seems obvious, but is too often overlooked when the buying decision is based on the monthly payment rather than the total cost over the life of the loan. The average length of an auto loan today has reached nearly 70 months, and can run up to 84 months (seven years). This can add a significant additional interest cost over the life of the contract.
In addition, the value of an automobile begins to fall the moment you drive off the lot. According to Edmunds.com, a new car loses about a third of its value during the first 12 months and around 10 percent each year thereafter. By the time you finish paying off a seven-year loan, the remaining value of the vehicle will have declined by 75 percent, implying that the loan will be "upside down" for most of its life.
A useful rule of thumb is to observe the 20/4/10 rule. Apply a down payment of at least 20 percent, finance the car over four years, and ensure that the total annual cost of ownership is less than 10 percent of your income. Total annual operating costs include loan expenses, insurance, fuel, maintenance, and depreciation, and runs about $8,850 per year for the average motorist. If you must exceed these limits, it probably makes sense to consider a less expensive vehicle option.
Another key to a successful transaction is preparation. Do your homework before walking onto the showroom floor. For example, you should know your credit score before beginning the search. According to a survey by used car marketplace Instamotor, only half of all buyers are armed with this information (just 25 percent of shoppers under age 25). This is important, since the interest rate you will incur is a function of your credit history; higher FICO scores mean lower interest rates.
Take the time to get a pre-approval letter from your bank or credit union before you buy. This gives you a bargaining advantage when it comes time to talk turkey at the dealership. Of course, the dealer will try to keep the financing in house, and you may find that manufacturers sometimes offer compelling terms as an incentive, which is perfectly acceptable if it saves you money.
If you happen to have a dented credit history, you will pay more. However, as your credit profile improves over time, don't forget to look into refinancing the high interest loan into more affordable terms. Just don't extend the maturity of the contract.
In general, extended warranties are poor bets, and are typically folded into the loan balance. You might consider such a purchase if you may not be able to cover an unexpected repair, but the odds are definitely loaded in favor of the house.
Finally, take the time to run the numbers first. There are many calculators on the web to assist you in estimating the costs of your loan over its lifetime. A good example can be found on Nerdwallet.com. Edmunds.com also has a depreciation calculator to show just how fast the value falls once you turn the key.
Smart car shopping begins with preparation and an eye on the budget. Avoid the temptation to buy too much car based solely on the monthly payment, and you will save thousands over a lifetime of driving.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager at Barnett & Co. in Chattanooga