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3 Common Misconceptions about Budgeting for an Auto Loan

Everyone has a budget. Everyone. Whether you are purchasing a t-shirt or a used car, you will have probably set specific parameters for how much you are willing to spend. The parameters you have set are almost certainly related to your monthly income, your saving and spending habits, your monthly bills outlay, and your comfort levels in taking on debt. The similarities of buying a used car and a t-shirt end shortly into the discussion, unless you are paying cash for a vehicle and then your budget is some fraction of the cash you have in your bank account. While you are budgeting, avoid making the following mistakes.

If you are not paying cash for your vehicle and therefore plan to finance it, your budget may be simple to define based on your finances, but finding a vehicle that fits your equation may not be as straightforward. The important thing to realize is price is only one of a few important components of a car payment, and understanding the other components is important as you look for your next vehicle. Consider the following as you search:

Low price doesn't always mean low payment

It is a common misconception that the lower the price of the vehicle, the lower the monthly payment will be. Typically, ultra low prices on vehicles mean the vehicle is either older or has higher mileage than average. What this means for a bank is a loan on the vehicle will be at a higher risk level than average. Banks correct for this risk with either a shorter term or higher interest rate than you might otherwise qualify for. To get a rough idea of how this works try dividing 12,000 by 60 and then divide 6,000 by 24. If your calculator is correct, it will be 200 and 250. Get the picture?

Interest rate is important, but not as much as you think.

Before reading this, download this finance calculator. For this demostration, in the finance calculator enter $12,000 as the amount financed. Set the term to 60 months and then enter the rate at 5.99%. The payment should be $231.92. Now change the rate to 6.99%. The payment should be $237.55. Not really that big of a change and I highly recommend treating your monthly payment a minimum requirement: you should always contribute more to reduce the amount of interest you pay. However, the big difference comes in drastic rate changes. Try punching in 12.99% into the example we were working on, the payment will be $272.97.The takeaway here is to figure out an estimate of what you qualify for and use that to budget, but don't sweat the rate too much.

Term matters, a lot.

Continuing our example from above, keep $12000 as the amount financed and the interest rate at 5.99%. Now run the term at 48 months, 60 months, and 72 months. The payment should come out to $281.76, $231.96, and $198.81 respectively. A 24 month spread comes out to almost a $100 a month less in payment. Obviously, you will pay more in interest, so it is important to balance your budget with the amount you are comfortable with paying in interest. As I said before, the best way to treat a monthly payment is as a minimum suggestion, as opposed to the actual payment to pay down interest faster.


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