Buying a Car: Paying Cash vs. Auto Loan

When The Ides of March sang “I’m your vehicle; I’ll take you anywhere you want to go,” they were definitely not referring to YOUR car, which really doesn’t take you much of anywhere anymore. All indications point to the urgent need for a replacement set of wheels, so that you can put your old clunker – that spends more time in the shop than it spends on the road – out of is misery. Sound familiar?

If this situation sounds like your life, you are probably already looking at new vehicles. But should you finance the cost of a new car with a loan or settle for a used car for which you can afford to pay cash? The answer depends on several factors, not the least of which is your budget.

Why You Should Purchase a Car Upfront With Cash

paying cashBefore the housing bubble burst, the prevailing wisdom stated that property values had nowhere to go but up. As a result, purchasing a home represented a wise investment. Of course, the collapse of the housing market disproved this truism once and for all.

This truism has never applied to cars. In fact, it is often said that the value of a car drops significantly the minute you drive it off the lot. It is almost a given that you will eventually be upside down on a car loan, unless you make a large down payment and take a loan with a very short term.

In fact, car loans possess the worst qualities of credit cards and mortgages. Car loans resemble credit card debt more than student loans or mortgages in that neither your payments nor the interest are tax deductible. But car loans are also like mortgages in that the lender can and will repossess your vehicle if you fall behind on your payments.

By contrast, when you pay cash for a car, the car is yours, free and clear. Unless you use the car as collateral for another loan or line of credit, or declare Chapter 7 bankruptcy, there are very few legal means for anyone to take the car away from you. And unlike a leased car, you can paint your fully-paid-for car any color you like, completely redo the interior or install a stereo system where your spare tire would ordinarily be stored.

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Why You Should Take Out a Loan for a Car

auto-financeGiven these factors, it would seem that it never makes sense to take out a loan for a car, but this is not the case. There are actually three instances where it makes sense to finance the purchase of a car:

  1. When you are financing a new car which you intend to keep for several years. Purchasing a new car and essentially driving it into the ground allows you to extract the maximum value for your expenditure.
  2. When you are purchasing an antique, classic or collector-worthy car. Many classic or collector cars defy the common wisdom and actually DO appreciate in value. This kind of thinking really only works however, if your new “investment” is projected to appreciate in value at a rate greater than the interest rate that you end up paying on the loan.
  3. If you have the cash to pay for a vehicle and don’t need an auto loan, you may still want to consider financing if you can find a low enough interest rate. By finding a super low APR, you can take the cash you would have used to pay for the vehicle and instead invest it. The reasoning behind this method is that you could actually end up making your money work harder for you if you put it in the right place. However, this option only makes sense if you find and qualify for a low APR loan, and then take the cash and invest it in a relatively secure and long term option that has a return rate higher than the APR on the loan.

Of course it may be very tempting to finance a loan that will allow you to buy a brand new car, or to get that top-of-the-line model with all the latest bells and whistles, but it is very important that you think this option all the way through. One could even try to argue that new cars have more safety features and other innovations, not to mention the factory warranty to cover major repair issues that could arise, and are therefore more worthy of your investment. But remember that just like with any other type of loan, there are interest and fees that will go along with it, and it is important that you take into consideration the long term cost of the vehicle once that final payment is made.

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While having the luxury of being able to make payments over time is convenient, if you are not careful this could end up costing you more than it’s worth. The best time to opt for financing the cost of a new car would be when you can qualify for a really great rate. Always do your homework and try to find the best rates before settling for the first one that sounds good. Many lenders offer financing promotions that could get you a rate as low as 1%-2%, but you will have to do some leg-work to find them.

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A consumer’s credit score should also play a large part in their decision making when they are considering whether or not to take out a loan to purchase a vehicle. The average interest rate on a used car is around 8.56%, nearly double the average interest rate of 4.46% for a new car loan. But when you take into consideration the borrowers specific credit score and the interest rate they will qualify for, the numbers can vary drastically. According to Marketwatch.com, the average financed amount for a used vehicle is $18,000 and loans are typically paid back over a six year term. Depending on whether a consumer finances a new or used car and how good their FICO score is, the total cost of an auto loan using those figures can vary by as much as $10,000 or more.

Final Actual Cost

Another issue to take into consideration is the fact that even with a new car, the value of your vehicle drops significantly the moment you drive it off the dealership’s lot. According to Experian, used car buyers owe 131.1% of the vehicle’s value on their used car loan compared with 110.5% for new cars. That means that on a $20,000 car with 100% financing, an individual who buys the used car would owe $26,000 while a new car borrower would only owe $22,100. This illustrates the fact that if you do opt to finance your next vehicle, you would be far better off buying a brand new one.

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Making a Final Decision

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If your heart is set on obtaining a certain make and model of a car with a specific list of features, you will almost certainly be in the market for a new car, and perhaps a new car loan. If you can afford a decent down payment and the monthly payments do not impose a financial strain, go for it. Just know that you are not making an investment, but indulging in a desire, which is fine if you can afford it.

On the other hand, if your budget is tight, or if your job situation is marginal, taking a loan for a car is a risk you should seriously reconsider. If you absolutely need a car, shop for the best used model car that you can afford – and pay cash. Your budget will thank you.