Should I Finance a Car, or Pay Cash? Calculating the Costs
If you can pay cash for a car, it's still worth considering if you should finance a car or pay cash.
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As you consider purchasing a car, you can work out the costs in a variety of ways. Most people rarely stop to think, should I finance a car or pay cash? Even if you have enough savings to pay in cash, you should compare your interest rate and savings return rate to understand if you're making the right decision.
So, how do you make the choice? Here are some of the benefits and drawbacks of choosing to finance a car when you have the option to pay cash.
What is Your Personal Attitude Toward Debt?
Your attitude toward taking out a car loan may be more than just a logic-driven evaluation of pros and cons. Some families may have unconscious money mindsets ranging from "we never buy anything that we can't pay for in cash" to "substantial but strategic debt allows us to live the life we want." If you value the freedom of owning something outright, you are probably more interested in paying cash for a car. If you prefer to invest your savings and pay reasonable interest over time, then a car loan might be a better deal.
Most people agree that high interest rates create wastefully high costs. No one wants to pay high monthly payments that don't fit into your monthly cash flow. However, car loans are often offered in reasonable payment sizes for a reasonable term with a lower interest rate than other consumer debt. That is because they are secured by the vehicle, meaning that the lender has the ability to repossess the car if the borrower stops making payments. If you qualify for a good interest rate, financing your car could free your savings to be invested or spent elsewhere.
What Else Can Your Savings Do?
If you saved money to buy this car without debt in a low-interest bearing account, you may not take on much interest. When you ask yourself, should I finance a car or pay cash, it's not an easy choice. Choosing to fully pay off your vehicle could be a great deal for you. However, financing a car at a reasonable interest rate while investing your savings could actually yield you a better return on your money. For instance, if you invest in a mutual fund that typically achieves a 10% rate of return each year, and your car loan's APR is 5%, you could effectively achieve a 5% return on your savings as you pay off your loan.
In reality, this return wouldn't be quite so cut and dry, since you may owe taxes on returns on mutual fund investments. Investments have varying returns on investment depending on the market, and you could owe fees for drawing on those savings each month to pay for your car payment. Even in this simple example, however, there is room to earn a return on your savings rather than spending savings all at once on a paid-off car.
If you qualify for a low annual percentage rate, all you need to do is learn how to calculate finance charges on a car loan payment. A simple way to do this without a lot of calculations on your part is to use an online loan calculator; just input the length of the loan, the original amount borrowed, and your APR. Part of what the calculator generates is the finance charge, or the total amount you'll pay in interest and other fees included in your APR. For instance, a $20,000 loan for four years at 5% APR would yield a finance charge of $2,108.12.
Divided over the four years, this works out to only $527 per year to borrow money. Shorter-term loans can sometimes have even lower charges — the same loan paid back over three years only costs $1,579.05 total. In some cases, investing part of your savings and using the rest to pay down your loan could yield more than that finance charge when invested in some way; if you invested $15,000, leaving $5,000 available in your checking account to make sure you could pay your car payments every month, and got a 10% return, you'd gain $1,500 in just a year.
Once you've looked at the finance charges for your own potential loan, you can compare the average rates of return for various investment options and make your decision on cash versus financing based on weighing the rate of the returns against the interest rate of the loan.
What Are Your Priorities?
The positive feeling of owning a car outright can be valuable for your peace of mind. On the other hand, financing a car can give you a stronger savings cushion for investing or paying unexpected expenses. Financing a car becomes a particularly good option if you choose a shorter-term loan — usually 24 to 48 months — with a low interest rate. Regardless, knowing your options up front may save you money in the long run. The decision of 'should I finance a car or pay cash?' is something worth considering in depth.
