Monthly payment versus total cost | Car buying | Financial Literacy | Khan Academy

In this video, we're going to explore the tradeoff between trying to lower our monthly payment while also trying to lower the total amount of money we pay out to get a loan for a car. In this scenario, although this trade-off is true for many types of loans.

So let's say we are buying a car. We're putting some money down, but then we have to borrow the rest, and let's say we have to borrow $115,000 in order to buy this car. Now, what this table shows us is different terms. So, if we wanted to pay this off over 36 months, which is three years, four years, five years, or six years.

Now, what's interesting is, depending on the length of the term, the interest rate is likely to change. It's likely to be higher for longer-term loans when you pay it off over a longer period of time, and generally, that's because the person lending you the money is taking on more risk if it's going to take longer for them to get their money back.

So here, we're assuming that the lender is willing to give you a 6% loan for 36 or 48 months, but then it goes up to 7% for 60 or 72 months. Now, based on these, you could use a payment calculator to come up with these numbers. These are the monthly payments we get.

Now, as you would expect, the longer the loan term, the longer it's taking you to pay things off. You do see a trend that your monthly payment goes down. It goes down if you're paying it off in three years; it's $456. If you're paying it off in six years, so twice the amount of time, it doesn't quite go to half, but it's a lot lower—$250, almost $256 here.

But here's the catch. If we think about the total amount that we are paying back to the lender when we do it over 36 months with a 6% interest rate, the total amount that we are paying back is $6,428. Or another way to think about it in this scenario right over here, we paid back the $115,000, and then there's another $1,428 that we paid in interest. That's essentially how the lender makes their money.

So that's what we paid back over there, but look what we're paying back in this six-year scenario for that same $115,000 loan. We pay that back plus we pay another $3,413 in interest. Even though the interest rate is only a little bit more, we're paying that interest rate over a longer period of time, so this is something to really keep in mind.

Now, as I've touched on in other videos, there's other reasons why you want to go closer to the shorter end of the spectrum over here. You definitely don't want to end up in a scenario where your car depreciates so much. That's—you have to be careful, try to get a car with a good resale value.

But there have definitely been scenarios where people get upside down on their loan, which means let’s say they got a six-year loan and five years have gone by, and they want to sell that car, but the amount of money they get for the car, the cash amount, is actually less than what they owe on a loan. You do not want to be in that scenario.

There's also scenarios where maybe you're in year five of a six-year loan—and obviously, this is not a scenario we want to be in—but let's say you get into a car accident, your car gets totaled. The insurance company doesn't care about your loan; in most cases, they're just going to pay you the cash value of the car.

If the loan amount is still pretty high, especially compared to that cash value, that probably isn't a good financial situation to be in. And that's above and beyond just the psychology of if you're able to pay it off sooner. You're able to be free and clear sooner and use that cash for other things.