Car Finance Canada
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How Car Loans Work

There’s just something so tantalizing about a low monthly payment when you’re in the market for a new vehicle, but many don’t realize that they’re actually paying much more in the long-term by extending the length of their loan just to lessen the monthly cost.

So, how does a car loan work? How does the math work out here exactly? If you’ve been car shopping and looking at potential loan options, I’m sure you’ve seen how many directions you can go with how to purchase a vehicle. It’s almost overwhelming at times! So let’s try to simplify it by looking at the whole process and how it rolls out over time.

A car loan is lent to you in one lump sum, and then you are required to pay it back over an agreed-on time period, plus interest. There are several factors that affect how much your monthly payment ends up being, like how much the car costs, how much you borrowed, what the interest rate is, and how long the pay-off period is. However, out of all the externals that affect your car payment, the most significant ones are the loan term, the annual percentage rate, and the loan amount.

Your annual percentage rate — more commonly referred to as an APR — is the interest rate you are required to pay on the loan. The loan term is the is the time period you and the loaner have agreed on in which you are to pay back the loan in full; this is usually around 36-72 months. The loan amount depends on your own needs. If you have a trade-in vehicle or are able to make a down payment, your loan will be much less than the car’s value.

So how do these three main factors work together to produce your monthly payment? Well, let’s look at them one-by-one in a real-life example. You’re looking at a car that is $25,000, but you’re able to trade in a vehicle, shaving off $2,000. That takes your loan down to $23,000; assuming you’ve agreed on a 4-year loan term and your APR is 3%, this would make your monthly payment $44.27 less. However, if a different institution offers you 2% APR instead, you’ll save $10.98 a month – an offer you shouldn’t refuse! But if an institution offers to extend your loan term an extra year, making it 5 years instead of 4, your monthly payment may go down, but the overall cost will go up. For example, if the APR is 3%, your monthly payment will go down by $104.14, but in the end, you’ll end up paying $391.85 more because the interest charges have been extended a year.

As you can see, you’ll want to be starkly aware of the duration of your loan period and what your interest rate is. It might seem great at first to have a drastically lower monthly payment, but when all is said and done, you will have paid a lot more than necessary.

Let’s look again at that $25,000 car loan with a 3% APR and assume the loan period is 48 months. That will leave you paying $1,562 total in interest; however, extending the loan to 50 months increases that to $1,953 even though it simultaneously takes your monthly car payments down by $104.

At the end of the day, we’re all in different situations, wanting different things, and holding different resources. Even with the increase of total interest paid, a longer-term may be what you need to afford the car you want to buy. A higher monthly payment, however, will almost always mean you’re paying less in the long-run. Whatever you do, be sure to weigh all your options, take the time to consider and truly understand them all, and make a well-thought-out decision that you and your bank account can handle.