By Eric Jorgensen
Learn more about Eric on NerdWallet’s Ask an Advisor
When buying a car, you have two options: take out a loan to finance the purchase or pay for it in cash. There are pros and cons for each approach, and as with any financial decision, it ultimately depends on what works best for your situation.
But one notable benefit of financing is that it frees up money for investing. So if you have good credit and plan to buy soon, while rates are low, financing your purchase could be the smarter move.
Lets look at how financing and investing could be more profitable in the long run.
How financing works
When you apply for a car loan, lenders will look at your credit score to determine how much of a risk you are as a borrower. The interest charged on the loan is driven by your credit score: The better your score, the lower the interest rate and the lower your payment. If you have an above-average credit score — say, over 750 — it’s likely that you can get a very low interest rate; in some instances, it could be as low as 0%.
You also have to decide how long you want to make payments. Typically, the range is from three to six years, but it’s best not to go over five years. The longer you stretch out your payments, the lower the monthly payment will be — but note that longer terms can also carry higher interest rates.
Your monthly payment is also based on how much money you pay upfront as a down payment. For example, if you buy a $30,000 car with no money down, financed for five years at 3.5% interest, you can expect to pay approximately $550 a month. However, if you put $10,000 down and everything else stays the same, your payment would drop to approximately $370 a month.
So how much should you pay each month? (Note that I did not ask how much you could afford.) In reality, it’s best to keep your monthly payment below the amount you can technically afford based purely on your expenses and income. Just think of all the other costs of owning a car like maintenance, insurance, fuel and other expenses that may come up.
I recommend keeping car payments below 5% of your net income after taxes. As a financial advisor, the last thing I want to hear is that someone can’t save money because they are “car poor.”
Biggest benefit of financing: Investing
Paying cash requires disciplined saving in low-risk buckets — perhaps bond funds or high-yield savings accounts. To buy a $30,000 car, you’d need to save about $470 a month over five years, assuming a 3% rate of return, or $500 a month with a 0% interest rate. For many, that’s a pretty high amount considering other savings needs.
New cars depreciate quickly, some estimate by as much as 20% when you drive off the lot, 30% by the end of the year, and 50% within three years. It’s not a good idea to take a large amount of cash and sink it into an asset that is going to immediately lose value.
Today’s low-interest-rate environment makes financing, rather than paying cash, an attractive option.
Assume you have determined the amount you can spend each month and can purchase a car by putting down no money, or the bare minimum amount. This allows you to instead invest, or keep investing, the money you could have used as a down payment.
Using the above example: If instead of using it as a down payment, you invested $10,000 for five years at an average annual rate of 6%, your funds would grow to nearly $13,400, a potential $3,400 gain. If you used the $10,000 as a down payment on the car and then invested the $180 a month difference in your car payment ($550 $370) under the same conditions, your funds would grow to just about $12,400, a gain of $2,400 over the original down payment amount.
Note that when you invest, theres no guarantee that the market will do well and your money will grow. But the longer you keep your money invested, the better are your chances of seeing positive returns.
At the five-year mark, interest on the auto loan could cancel investment gains. However, if you withdraw $10,000 from your investment account for a down payment, youll forfeit any gains over five years and much more over your lifetime. During low interest rate environments, like the one we are currently in, it makes more sense to minimize the down payment and let your investments compound.
If you paid 100% cash, you miss out on the opportunity to invest and grow those funds and you’d have to build up new savings.
Drawbacks to financing
Besides the purchase price, the other cost to consider when you finance a car is how much money you’ll pay in interest over the years of your loan. With a five-year loan, no money down and a rate of 3.5%, you’re paying about $2,750 extra over the life of the loan, making the total cost of the car $32,750; this increases to about $6,900 at an 8.5% interest, making the total cost $36,900.
And note that if you are purchasing a new car before your old car is paid in full, in most cases you end up rolling your remaining debt into the new loan, increasing what you owe, and subsequently increasing the amount you pay each month. It also means there is the potential for a significant gap between the new car’s value (what you’ll get from insurance in the event of an accident) and what you owe. Say you buy a $30,000 car and you still owe $7,500 on your old car. This means you finance $37,500, but the best you can hope to be covered by insurance is $30,000.
Also know that when you have a loan, you may be required to get complete auto insurance coverage, even for a used car that may not be worth it. When you own a car outright, you decide what amount and types of insurance to purchase. This means you don’t have an opportunity to decrease your monthly spending by purchasing insurance based on your needs rather than what the loan terms dictate.
However, it’s also important to remember that interest rates won’t stay low forever. This means payments will be higher in the future and could make financing the more expensive option. And remember, if you don’t have a high enough credit score, you also won’t have the benefit of getting a low rate on your loan. In these cases, you will need to put more money down to drive the monthly payment down, making financing less attractive.
There are many variables to consider when deciding how to buy a car, and it ultimately depends on your situation and how much you can realistically afford. By financing your car and investing the amount you would have used as money down, you could potentially make more than if you pay part or all of it upfront. However, this only works if you actually invest the money and don’t spend it on something else.
Eric Jorgensen is a fee-only financial planner with MainStreet Financial Planning in Silver Spring, Maryland.
This article also appears on Nasdaq.