So you had enough foresight to determine the price range for your new car before you started shopping in earnest. You did everything right: you calculated a maximum price you were willing to pay, and committed to it. You researched the Kelley Blue Book values, spent a Sunday looking at VINs on the lot (or online) and taking notes, and pitted multiple dealers against each other. Then, ideally, you made your final offer sometime in the early evening on the last day of the month – to a panicking salesman desperate to make his quota.

After all that, it’s still not over. Time and again I see people save money on big transactions, only to give back what they saved and then some on financing.

Why? Because financing is more complicated than pricing, and has multiple variables involved; not just a price, but an interest rate and a time period.

Given the choice, you should always take high-price/low-financing over low-price/high-financing. Or at least measure the difference between the two before deciding.

Let me give you an example. The average price of a new car is around $28,400. Say a dealer offers you a choice of 5-year financing plans at:

a) 0%.

b) 7%, but he’ll lower the price 10% to $25,560.

Which is the better deal?

With 0% financing, figuring out the monthly payment is obvious. With interest, it’s more complicated.

WARNING: What follows is an equation, complete with parentheses and powers and stuff. Don’t complain when you see it and think it’s complicated. I’ll walk you through it.

.07 is the annual interest rate, 12 the annual number of pay periods and 60 the total number of payments. Take your annual interest rate. Divide it by the number of months in a year. Add 1. Figure out where the calculator’s exponent key is, then press “6”, “0”, and the plus-minus key. Subtract from 1, multiply by 12, divide into your interest rate, multiply by the sales price. DONE!

The salesman won’t go to all this trouble, of course. He just needs to read off a list of approved price/financing combination issued from the corporate office. A list that you don’t have access to.

Take the 7% financing, and you won’t be paying close to $25,560. You’ll be paying over $30,000. Lowering the price by a certain percentage while raising the interest rate by a smaller percentage is the first parlor trick the dealership teaches to rookie salesmen. Don’t be duped by this. Here’s a chart that explains the potentially fatal difference:

Besides, you should probably get your financing in place before you negotiate. Go to your bank, your credit union, a competing bank, it doesn’t matter. Only once you get a dollar figure and an interest rate approved in writing should you start shopping for cars.

This makes inherent sense, and it’s the reason why lenders run a credit check. Think about it: low-price/high-financing is available to almost anyone. High-price/low-financing is something you have to qualify for. A lender will make it as easy and effortless as possible for you to overpay them.

If you think low-price/high-financing is bad on a car loan, it’s even worse for a mortgage.

Using Freddie Mac’s own numbers, average 30-year fixed rates are at 4.35% now and were 5.06% a year ago. Say you wanted to finance 80% of the purchase price of a median-priced home a year ago. (80% is the threshold at which you’d save the price of private mortgage insurance, which is the premium that lenders charge to people who pose a credit risk by not putting enough money down.) That’d be 80% of $207,100, or $165,680.

This is only the amount financed – not the entire purchase price. Plug the numbers into the formula above, and you’d be making monthly payments of $895.49.

At today’s 4.35% rate, making the same monthly payments, you’d be able to borrow as much as $179,886 – which is 80% of $224,857.

Given how far interest rates have fallen, with the lower rates you can now pay “median” prices to buy a home 8% more expensive than the median. Interest rates are powerful. Always do the math and don’t let any salesman push you into a deal you’ll regret.

*This is a guest post by Greg McFarlane, who runs ControlYourCash.com and wrote Control Your Cash: Making Money Make Sense, a financial primer for people in their 20s and 30s who know nothing about money. You can also find the Kindle version here.*

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{ 12 comments… read them below or add one }

This is a much more complicated comparison. We can easily compare the two schemes by getting the annual percentage rate multiplied by 5 years, thus you get an additional 35% increase from the base price. 35% increase less the 10% discount given by the dealer, still leaves a 25% increase from the price of the car compared to 0% financing.

That’s what I would have done as well. It’s easier.

urghh…. too… much… math…

I paid cash for my last car so I skipped through until the mortgage part.

It seems silly to be working backward from monthly mortgage payment to see the total price. This is a trap that car dealers use. If you are working from the monthly payment, they can always fool around and jack up your total price somehow ie. change term length. IMO, it’s better to start any purchase calculation with OTD price. You can always refinance if rate goes down.

Steve you are wrong.

You can’t multiply the APR by 5 and get the interest. The interest is calculated on the total owed, not all at the beginning.

A basic example to illustrate the point,

$1000 loan at 5% interest

Year one, 50$ in interest, $1050 owed. $20 a month is paid and at the endof the year you have

$810 loan at 5%

Year 2 40.50 in itnerest $850.50 owed.. $20 a month is paid and at the end of year two you have

$610 loan at 5% etc.

First, make sure you have better financing available. Then take the lower price they offered and re-finance. Or take the lower price and accelerate your pay-off.

We can all have our own tricks up our sleeve. And of course one person mentioned they pay cash. They could have taken the lower price and paid off the car the next month.

Of course make sure there aren’t any early payoff penalties, but I can’t think of hearing of one of those on an auto loan.

cd :O)

It is wiser to buy a car on cash for me; the ease of having no monthly due is a great way to save more money than paying a high interest in financing.

This is why I have been buying from Enterprise Car Sales. It’s the sales part of Enterprise Rent-A-Car that doesn’t haggle with the prices and you are in and out and pay less than KBB every time. The financing is great because they don’t charge you a higher rate than the banks come back with.

They sell used certified vehicles with about 30k miles or less. The guys there tell me that since they can’t advertise they really can’t sell any beat up ones because it will result in customers bashing them. Good group of people that actually care about what their customers want.

I agree that enterprise sells some nice vehicles.

I purchased a fairly deluxe (not toy crazy van); that was bought back from enterprise by Chrysler & then put a 8 year or 80,000 mile bumper to bumper guarantee with a 100. deductable for $1400.

Buy the way i know dealers make 50% profit on service agreements.

I used to sell them but with the pending cost of quality service I wanted Chryslers guarantee. believe it or not even Honda was willing to sell me a extended warranty but I gambled that Chrlsler would weather the economic

holocaust we were in but the Govt. didn’t want to admit it in May to June of 07 I can tell you Govt stats or what ever we were already deep in mud it just haden’t dryed or hardend yet.

I paid more than 10,000 less than a new one and it felt safe having a Country wide guarantee from Chrysler.

I enjoyed your article.

Say what State or country do you live in?

Maybe we could have coffee & a bite to eat.

A new rule of thumb: only buy cars if you can afford to pay in full without financing. Of course our culture makes this very difficult to do. I understand that sometimes we need to get a loan such as our homes, but I see too many people having difficulty managing debts. The best thing do to is minimize debt as much as possible. I guess for those who really need a car will have to take the loan since we cannot live without a car.

Paying in monthly rates for more years has always got the product to an over price, I prefer buying and paying all at once, for no further surprises, and I know that this way the price I see is the price I pay

I totally agree on this one. If you buy the full price for your preferred time then it will cost you some interest and the longer you will pay the higher the interest you will have.

When buying a new car, the salesman always wants to add on a bunch of stuff. Is it necessary to have these things added to the contract?