Understanding what the financing of a car will really cost you when you buy a car can be difficult - almost impossible to understand.
Here are a few facts to help you interpret what you hear and see when financing a car:
1. Leasing may allow you to drive a car you can't afford
. Of course, if you lease a car, the finance company will underwrite your lease in the same way a lender would underwrite your loan to determine if you can qualify. Just because you qualify, doesn't mean you can afford the car. Leasing puts you in a situation in which you will never own the car.
2. Zero percent financing may not really be 0 percent
. If a dealer offers you a 0 percent financing option, but at the same times offers you the chance to buy the car for cash and pay less, that isn't 0 percent financing. You're really just paying all of the financing costs in the price of the car.
3. Know the key variables to a loan
. You can negotiate on a more level playing field if you understand the math behind loan financing. Here are the key variables:
The amount of money you borrow represents the principal amount of the loan. Often times, this can be 100 percent of the purchase price, including sales tax and other transaction fees. In other words, the principal amount of the loan can be much more than the car is worth even before you drive it off the lot.
The interest rate is an annual rate; each month as you make your payments, you reduce the principal balance and the interest you pay is also reduced. Your early payments have more interest in them than your later payments. Unlike a mortgage payment which has more interest than principal initially, car loans are generally so short that the principal exceeds the interest even in the first month of the loan.
The length of the loan is a key variable (more important than interest) for determining your payment. The longer your term, the lower your payment. Optimally, you'd like to drive the car for several years after you pay off your car so that you can pay cash for your next car. If your car loan is too long, your car may not be running much longer than the term of the loan. Be careful with loan terms of five years or more.
4. Know the variables to a lease
. Leases are more complex than loans and thus create greater risk. You may end up paying much more than you bargained for:
The principal amount of a lease is not an explicit element of the lease; it is implied. Your lease document will never refer to it. In order to calculate the payment, however, the finance company has to know what it is. It is a different amount than with a loan; in the case of a lease, it excludes sales tax (which is added to the monthly lease payment rather than being included in the lease).
Again, the lease terms won't explicitly refer to an interest rate, but the lease is calculated using an implied interest rate.
The lease, as with a loan, has a term. At the end of the lease, you return the car and walk away owning nothing. You may, however, owe something. Continue reading.
A lease will limit you to a specified number of miles. If you drive more than the lease allows, you'll be penalized when you return the car. If you drive fewer miles than allowed, you won't get a refund.
The lease may not specify the residual value, but it is required to calculate the lease payment. Generally, you are given the option to buy the car at a predetermined residual value at the end of the lease. If you love the car, or would owe a large mileage penalty at the end of the lease you may want to exercise the option to buy the car.
The lease payment is due in advance. When you make your payment on the first, it entitles you to drive the car for the next 30 days. Hence, you'll generally have to make the first lease payment at the dealer.
At the time you lease the car, you may be required to pay additional fees up front. These effectively serve as a down payment, reducing your monthly payment.
5. Leases can trap you
Given all of the variables in a lease, it is easier to get trapped with terms you didn't understand fully or appreciate. If you pay $2,400 down when you lease a car and are excited that your payment will only be $200 per month for your two-year lease, you may have missed the fact that you are really paying $300 per month for the car. Depending on the car and the mileage limits, that may not be a good deal at all.
Be careful when you buy a car. Although cars are not investments, do not appreciate and the term "equity" makes a tinny sound when applied to a car purchase, you are much better off generally to save your money and buy a car you can afford to buy for cash. Otherwise, you risk overspending on cars and allowing that to hurt your ability to pay for more important things like college for your kids and retirement.