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:
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.