Car Financing

Car Financing Explained: Understanding the True Costs

Americans owe almost $1.5 trillion in car debts, which is 9.4% of all consumer debt, and equal to the nation’s student debt. That’s a massive amount, but it’s not necessarily bad to have car debt if you’re aware of the costs of car financing and can afford it. That being said, lots of folks are neither, which has resulted in many Americans badly overpaying for their cars or even going bankrupt. 

Of course, most people need a car, but you don’t have to get a bank loan to afford one, and I’ll teach you how. Ultimately, whether you borrow for a car, or not, you should be fully aware of the costs of financing to make an informed and responsible choice. 

What is car financing?                                  

Car financing is when you pay an up-front deposit on your car and pay the rest through monthly bank payments, just like a mortgage. Car financing sounds like the easiest way to get a nice new car. You pay a little up-front and the bank covers the rest while you make smaller monthly payments, everybody wins right? Well, mostly the banks do because financing is the most expensive way to buy a car. 

When you borrow money from anyone, you pay them the principal back with interest. So, you spend more overall than if you paid for the car up-front. The benefit of financing is that you get your car quicker and without having enough money. But, you should really ask yourself if the long-term cost is worth it. You should also know that lenders often deliberately make it difficult to calculate how much you have to pay.

How much do I pay for a car loan? 

Estimating the cost of car financing involves multiple calculations, including:

  • The principal
  • The annual percentage return (APR), which is the interest rate you pay
  • Your loan’s time period, which is normally measured in months
  • The trade-in value of a previous car if you’re trading it 
  • Any sales tax or other fees charged by your lender or state

Suppose, you take a $20,000 car loan at an average 5% annual percentage return (APR) for an average of 60 months without a trade-in, and you don’t pay any other fees or sales tax.

You’ll pay $377.42 per month for 60 months, or $22,645.48 in total. That means you’ve paid $2,645.4 for your $20,000 loan, or around $13.2 of the borrowed amount. That’s also assuming no sales tax or other fees, which you’ll realistically have to pay–sales tax and fees can easily add another few thousand dollars to this equation.

Now, this cost may be worth it to you. You might not mind paying an extra $2,600 in exchange for getting your car today–that’s personally fine. Whether or not you should finance a car purchase depends entirely on you and your priorities. It’s completely your choice. My only goal is to educate you on the pros and cons of car financing so that you make an informed decision. 

How to finance a car?                        

There are two main ways to finance a car: leasing and direct financing.

1. Direct Car Financing             

Direct financing is the financing approach I described above. You put in a downpayment and borrow money to pay the rest of the cost for a certain number of months. The interest rate you’re charged is the cost of direct financing, and it may or may not be financially sound for you long-term. 

It’s common for dealers to advertise enticing car financing options, like ‘Zero down payment and zero interest for the first 3 months’. That sounds like a great deal, and it even could be for you, but no down payment and no interest for the first 3 months means you’ll get a bigger loan and higher interest after the first 3 months. 

So, you’ll likely pay even more money with a ‘too good to be true’ sales pitch like this one. Also, direct financing for older cars tends to be more expensive for new ones. So, don’t think that financing an old car will cut costs–it likely won’t. 

2. Leasing

Leasing is generally the most expensive way to buy a car. You pay a lower monthly payment when you lease a car instead of directly financing it, but you experience higher overall costs and mileage restrictions. 

You borrow money from a bank or credit union when you lease a car, which you’ll pay back over time. Leasing a car also affects your credit score for that reason. 

When you lease a car, your payments are calculated by first totalling:

  1. The car’s expected depreciation (the loss of the car’s value during the lease period)
  2. Rent charges 
  3. Sales tax 
  4. Applicable fees

This figure is then divided by the lease’s time period in months, and you return the car at the end of your lease unless you choose to buy it. Most lease agreements also have mileage caps, so you can’t drive the car beyond the limit without additional fees. 

So, leasing a car is expensive, and you’re basically borrowing the car. Most people prefer directly financing a car instead. The only real advantage of leasing a car is that you’ll probably have smaller monthly payments.

I’d personally completely discourage leasing a car since the likely smaller monthly payments don’t make up for the many disadvantages of leasing. 

The hidden costs of car financing                

Like all other forms of debt, a car loan comes with hidden costs. 

1. Cars depreciate in value:                             

All cars go down in value over time. In fact, your shiny new car could lose as much as $15,000 to $20,000 in value in just 2 years. With direct financing, you’ll be paying the same monthly payments even when your car falls in value.

With leasing, you’ll actually pay the leasing company the likely depreciation of your car, so it costs you even more. Leasing companies charge you the depreciation since it’s the only way for them to say in business. 

2. You can’t get out of the agreement easily:                      

Most banks and financing companies make it difficult to leave an agreement. For example, most leasing companies will charge you multiple heavy fees for returning a leased car. 

These extra fees might even be enough to make leaving your lease not worth it. They obviously set all these disincentives to discourage you from leaving the agreement to avoid going into loss. 

3. Car financing Interest payments are hefty:                                      

Car loan interest payments can be very large. If you finance via a dealer, they’ll likely offer you lower mark-up interest but charge a larger interest long-term. This tactic is known as the ‘dealer’s reserve’, and it can easily cost you many thousands of dollars. 

Buying a car without financing                         

Like I’ve said above, financing a car may or may not be worth it for you–the alternative is paying cash up-front. When deciding whether it is, don’t think that you can’t afford to buy a car with cash unless you’re rich. 

Roughly 15% of cars are purchased without financing in the US, including purchases from non-rich people. So, buying a car without financing is completely feasible and plenty of people are doing it. 

Here is one 2-step way to buy a shiny new car without financing:

Step 1: Buy a cheaper used car                  

Buying a cheaper used car initially while saving to buy a better one later is a common car buying strategy. Your cheaper used car should be something you can afford up-front with cash. You’ll likely get an older car that isn’t as impressive as a brand new Mercedes, but it’ll get the job done. Let’s say you get an old Mazda for $1,500.

You can use the old car to fulfill your transportation needs while saving money every month to buy a better car later. This way, you’ll be able to drive now, and you can upgrade in the future. So, you can get that brand new Mercedes as long as you’re patient. 

The goal with this approach is to completely avoid debt.

Step 2: Save money for the new car 

If you save $500 a month, you’ll have $6,000 a year. You can use this money plus the trade-in value of your older cheaper car, let’s say $1,000 because of depreciation and get a new one for $7,000. You won’t immediately jump from a Mazda to a Mercedes for $7,000, but you can eventually land a Merc if you repeat this process every year.

The second year, you’ll have another $6,000 in savings and a more valuable car to trade in, let’s say it’s worth $6,000 after depreciation, so you’ll get a much bigger upgrade at $12,000. The following year, you could realistically have $16,000 for a car, then $20,000 the next year, and $24,000 after that.

That’s also assuming your savings don’t increase and your car moderately depreciates, so the actual calculations will likely be different. This process will also likely take several years to get you to a Mercedes from a Maza, but you’ll be completely debt-free.

Ultimately, again it’s your choice whether you’re willing to wait that long for the benefit of being debt-free. It’s completely up to you, but you should know about the benefits of paying up-front. 

What are the benefits of not financing your car?        

These are the 3 major benefits of paying cash up-front for your car.

1. No Interest rates

No interest rates mean lower long-term costs of owning your car. You also won’t have additional costs via increased interest because of late payments, which is common with car loan agreements.

Most lenders will renegotiate your interest rate if you make late payments, usually increasing it considerably.

2. No monthly payments                                  

Not having monthly payments means greater control over your finances, including monthly savings for your new car. You can save as little and as much as you want. You can even skip saving for a month during emergencies. With a car loan, you have to pay the amount no matter what.

Let’s say, you experience a medical emergency that costs $400. Let’s also say $400 how much you can either save per month for your car or pay for financing the car. With a car loan, you’d have to pay $400 to the lender then go into debt for your medical emergency. When you save your own money, you can’t just not save for a month.

3. You own the car                      

Most cars lose as much as 70% of their value in just 5 years. So, you’ll likely pay more than your car is worth with even a short-term car loan. For example, the Mercedes Benz S class has an average 5 year-depreciation of 69.9%. So, the 2022 Mercedes Benz S class starts at $110,000 in 2022, but it’ll likely be worth only $33,110 in 2027, which is a loss of $76,890.

You don’t have to worry about that when you own the car. The best part is that you can even sell your car early if you’re worried about depreciation. If you bought the Mercedes Benz S class up front, you could trade it the following year for the next model, saving you thousands of dollars. 

What should you do? 

Going into debt to buy a new car is virtually a religious practice in the United States in 2022. While it can sometimes make sense to pay more long-term for a car in exchange for getting it today, it’s probably not worth it for everyone. Car financing is expensive, and it’ll likely cost you thousands of dollars plus an additional loss of freedom to boot. 

There are also viable alternatives to financing your career if you’re patient and willing to settle for a less-fancy machine for the moment. Ultimately, finance a car or not, the choice is completely yours. I just hope you fully understand the pros and cons of financing after finishing this article and make an informed decision for yourself.

Author: Ramish Kamal Syed | Editor: Syed Hamza Ali | SEO Editor: Muhammad Waqas Aslam