You've got enough cash to pay for a car. But, there's that question in the back of your mind:
Is borrowing to buy a car really as unwise as some make it out to be?
In reality, there’s no easy answer.
It really depends on your personal circumstances – and preferences.
Even for people who are in a position to pay cash for a car, it’s not always the best strategy.
And while we should always do the best we can to minimize debt, financing a car is far from the worst strategy.
Learn about the pros and cons of both purchase methods.
Why You Should Pay in Full with Cash
According to AAA, it costs nearly $8,500 per year to own and operate the average car.
Part of that cost is comprised of interest on financing.
If you take a 60-month auto loan for $25,000 at an interest rate of 5%, your monthly payment will be $472.
The total of those payments over five years will be $28,320. That means you’ll be paying an extra $3,320 over and above the loan.
If the purchase price of the car is $30,000, adding financing will raise the total to $33,320 – an increase of about 11%.
There are three other major reasons you would want to pay cash:
1. Eliminating the monthly payment
In the above example, the monthly payment is $472.
Life and your cash flow, in particular, will be much easier without having to make that payment every month.
2. Eliminating the possibility of repossession
This isn’t a factor we like to think much about, but it also can’t be ignored.
The best part:
If you own your car free and clear, there’s no chance it’ll be repossessed by the lender.
Not only will that avoid a credit disaster, but it will also remove the possibility of losing the car.
And since most people need a vehicle in order to make a living, it’s certainly a situation worth avoiding.
3. You don’t like being in debt
Millions of people accept being in debt as a regular part of modern life.
On the other hand...
If you’re the type who doesn’t like being in debt, perhaps because you been in debt in the past and you don’t want to go back, paying cash will keep your debt schedule free and clear.
And naturally, all of the above assumes you have the cash available to purchase the car in full.
Why Financing a Car is the Better Strategy
The most obvious reason why financing a car is the better strategy is that you lack the cash needed to purchase the car in full.
The fact is:
That makes financing the vehicle entirely necessary.
But apart from necessity, there are two other reasons why you would want to finance the vehicle rather than pay cash:
1. Spreading out the cost of the car
The purchase of a car in full with cash is a big upfront expense.
From an accounting standpoint, it makes more sense to spread the cost of the vehicle out over several years.
That’s exactly what you’re doing by financing the car.
If you were to finance 100% of the purchase price on a five-year loan at 5%, your monthly payment will be $684.
That’s $8,204 per year.
Rather than paying over $36,000 in one shot, you would instead pay a little bit over $8,000 each year for five years.
And since a car is a long-term asset, it actually makes perfect sense.
2. Preserving your cash
Even if you have $100,000 sitting in the bank earning interest, taking out $30,000, $40,000, or $50,000 to pay cash for a car could put a serious dent in your savings.
It will be even more serious if you have to withdraw the money from investments.
Let’s say you have $100,000 in an investment brokerage account, earning an average annual rate of return of 7% (blended between stocks and bonds).
If you withdraw $40,000 to purchase a car, you will be losing $2,800 per year in investment returns.
It might be better to finance the car and keep your funds fully invested and growing.
Finance vs. Cash – Which Route Should You Take?
The decision to finance a car or pay cash mostly depends on your own personal circumstances.
That will involve a combination of your finances and your own personal preferences.
Let’s take a look at when you should pay in full with cash, and when you’re better off financing the car.
When You Should Pay in Full with Cash
You have enough cash to pay the car in full.
Paying cash for the car shouldn’t leave you in a weakened financial state.
To be clear:
You should have plenty of spare cash for emergencies or investments even after paying for the car.
Your income will be stretched with a loan payment.
It’s not unusual for people with relatively modest incomes to have a lot of cash in savings.
It happens when you’re a committed saver.
But if you earn $3,000 per month, you may decide that a $400 per month car payment will eat up too much of your budget. It may be better to pay cash for the car, and keep your budget clear.
Your job is unstable, and you don’t want to put your car at risk.
A car loan requires a stable income to make monthly payments.
If you need a car, but you’re concerned about your job, it may be better to pay cash for the car.
Should you lose your job, and be unable to make the monthly payment, you could be at risk of losing the car to repossession.
Your credit is bad.
This will put you in a position of either being declined for a loan, or paying a high interest rate that will make the car unaffordable.
If you’re forced to take a subprime car loan, you could be looking at an interest rate in excess of 20%.
That can make a high car payment even higher.
You’re planning to make a major financial move.
This can involve buying a home, or even starting a business.
For example, a large monthly car payment could force you to buy a less expensive home.
And if you’re starting a business, a car payment could cut into what will likely be a reduced cash flow.
When You’re Better Off Financing the Car
You don’t have enough cash to pay the full price.
Obviously, if you don’t have all the cash needed, you’ll have to turn to financing.
It might still be better to make a minimum down payment to preserve at least some of your cash.
When paying cash will leave you broke.
Owning a car free and clear will certainly be a good feeling. But it may be offset if you’re left with an empty bank account.
There’s a strong sense of comfort and confidence that comes from having money in the bank. You don’t want to leave yourself in a weakened position because of the car you’re driving.
You can earn more on your investing activities then you’ll pay in interest on the car loan.
If you can get a car loan at 5%, and you’re earning 7% on your investments, financing will make abundant sense.
By leaving your investments intact, you’ll continue to earn more than you’ll pay in interest.
Just as important, at the end of your loan term when your car is paid, you’ll still have your investment portfolio – plus the investment income you earned on it while you were paying off the car.
The interest rate on the loan is so low it’s almost like paying cash.
Some lenders are offering rates on car loans that are too good to pass up.
If you have an opportunity to get a loan for say, 2.99%, that will be very close to paying cash.
For example, if you take a $25,000 loan for five years at 2.99%, you’ll pay a total of $26,946 in payments. $1,946 of that will be interest.
Over five years, that’s less than $400 per year.
You can earn close to that interest rate with CDs offered by online banks.
This is really a question for people who are in a position to pay cash for a car. If you’re not, there’s no debate.
You’ll have to finance the car, and get the best terms possible when you do.
But even for those who have sufficient cash to buy a car without financing, the decision should never be automatic.
In a very real way, financing a car – with the best possible terms – can be a preferred convenience for the cash rich. Financing enables you to preserve your cash.
That not only keeps you in a stronger financial position overall, but it also enables you to use that cash for other purposes.
Purchasing a home or keeping your money fully invested are two prominent examples.
You may even decide it’s best to finance your car and use your cash to pay off high interest credit cards.
Even if you have the cash to pay for a car, explore the financing options available. It may be that the right loan will help you to make your decision.