Cut Your Car Loan Term to Save Cash

July 15, 2013 — -- Which is more expensive? A $300 a month car payment or a $400 one? The $300 one sure sounds cheaper, and that's the trap. If you pay less money but pay it for way longer, a lower monthly car payment can end up being more expensive than a higher one.

And yet that's exactly what people are doing. These days, 30 percent of all car loans are for six years, according to J.D. Power and Associates. And a five-year loan is still the most common of all.

Why is a long car loan generally a bad idea? Because cars depreciate so fast that some time in the not-too-distant future, you could end up owing more on your car than it is worth. I like to encourage people to pay cash for the cheapest used car they can stand. But recognizing that that's not possible for all people, I suggest a maximum auto loan term of two years.

Here's why. Let's say you're buying a car for $14,990 at 6.5 percent interest. If you make payments for five years, you will have actually paid $17,580 for that car. If you make payments for just two years, you will only pay $16,032 for it --a savings of $1,548 simply because you're not paying interest for as long.

True, if you choose the two-year loan you'll have higher monthly payments, but you'll have NO monthly payments after that. Most Americans keep their cars for only five years. That means the poor sap who took out the five-year car loan is likely to trade it in just as he's finished paying it off. He'll take out a new car loan and never enjoy the financial freedom of being out from under a car payment.

Still tempted by a snazzy car you can't really afford...unless you stretch out the payments for five --or now six-- years? You're making a mistake, but here's how to minimize your mistake:

• Buy a vehicle that holds its value well, so you won't be under water in it. You can get some ideas from the Edmunds.com Best Retained Value Awards.

• Shop around for the lowest possible interest rate. Only people with credit scores of 720 or above get the very best rates that car dealers hype in their ads. These days a rate of 2 percent or less would be a sweet deal.

• Keep your car longer. The longer you keep a vehicle, the more value you'll eke out of it. And you'll get the chance to see what it feels like to be car payment-free. Maybe you'll even be inspired to pay cash for your next car.