Next time you buy a new or used car will you be paying cash or financing it?
It’s these big financial decisions that can really make an impact on your budget and ability to reach your financial goals for years to come. This is a tough decision, and with the way interest rates are looking it’s only gotten tougher over the past few years.
Like many personal finance decisions, there are mathematical and emotional aspects to consider. On one hand, you could compare your cost of financing (i.e. interest payments, higher insurance, affects to credit score and ability to borrow) with your cost of outlaying that much cash (i.e. your money could earn more elsewhere).
On the other hand, you’ve got some emotional considerations, mostly revolving around your wants and the act of incurring debt. For me, it’s not an open-and-shut case.
An Example of Cash vs Financing
Let’s examine this potential purchase. I went to the Honda website and was greeted with an offer to purchase a new Civic for 0.9%. Let’s assume I’m a well-qualified buyer as the ad says is required. That means I could finance the new Civic for 0.9% over 5 years.
Let’s say I want the nicer model Civic and pick the one that costs $20,000. My payment would be $341, and my total interest paid over the 5 years would be…$460.87! If you are like me, you are saying, “that’s all!”. I ran the amortization schedule twice just to be sure.
But, yes, you would be paying a little over one extra car payment to have the ability to spread the purchase over 5 years. Using math as our guide, it’s fairly easy to suggest that financing is the best option. What could you do with $20,000 right now? Well, you could put it into a 5 year FDIC insured CD and earn 2.5% annually.
At the end of year one, your $20,000 investment into the CD would have netted you $500. In just one year your CD has already beat the cost of financing the car at the 0.9% rate.
But we all know that the math doesn’t present the complete picture. By taking on the $20,000 debt, you would be obligated to the financing company for at least 24 months. In our case, 60 months. You would have to get full coverage auto insurance based on the needs of the financing company. You would potentially decrease your ability to borrow money for a home (however, in some high-income cases, the debt may actually help).
If you’re not worried about debt or the short-term credit score effects, then the financing is the winner in this case. If you have an objection to debt, then no math formula is going to convince you. Just pay cash for the car. According to this NY Times article, that’s the number one reason people avoid car financing; they simply don’t want to have debt in their life.
Is Saving to Pay Cash for a Car Possible?
Backing up a bit, I think it’s fair to ask the question whether it’s possible to save up the $20,000 and pay for a car with cash. In our example, I had $20,000 lying around to make a purchase with. This isn’t money that is in my emergency fund. It’s not money in my retirement savings. It’s money that was saved up, either over time or from a windfall, with the intention of buying a car. Who has that kind of money? Who is disciplined enough to save up that much money for a car?
Not everyone can or will be able to do this. But that doesn’t mean it’s impossible. According to the same article cited above, about one third of the people who pay with cash, pulled the money from savings. Another third are selling stock to make the purchase. We’re left to assume whether this was stock in an account designated for retirement.
So while it’s clear that some people are able to make this purchase, it’s not clear whether they are going about it in the smartest way.
To begin saving for your car, why not designate a separate savings account and start putting a “car payment” into the account each month? At a minimum you will have a very nice down payment when you decide it’s time for a new car, and then you could just pay off the car loan as quick as possible.
One last thing to consider here is that you don’t have to buy a $20,000 new car. You could opt for a used car; something in the $10,000 range. Or you could possibly opt for a car under $1,000 and possibly go pay for a car today without needing financing. Then, start working your way up to a nicer, newer car as you continue to save.
The Best Way to Finance
There are some things you should know about financing if you decide to go that route.
First, you should never walk into a dealership waiving the 0.9% ad that got you in the door. In fact, you should not tell the dealership how you are going to pay for the car. They will ask, but don’t tell them. Tell them you have options.
How you are going to pay has nothing to do with your number one goal: getting the best price possible for the car. That should be your sole focus; not payment, not interest rate, not down-payment. Focus on the price of the car you are buying. Get that number down as low as you can get it. Bring information from Edmunds.com with you. Know what the invoice price is and what rebates there are available to the dealer.
Before you even step into the dealership though, you should have visited a local credit union or bank to secure your own financing. Credit unions have great rates (currently 2.75% in my area), and they will allow you to apply for the loan before you have the specific car in mind. You may not end up needing the credit union’s loan, but you just might. And it’s good to have that option when it comes time to pay.
Another thing to do before you go to the dealer is to check your credit score. If you have a top-notch score, you can demand top-notch financing. Having all of the information is key before you walk into this place.
Back to the dealership. Once you’ve negotiated the best possible price for the car, now it’s time to talk financing. Tell them you saw the ad for the 0.9% financing and you want that rate. Tell them that you have a solid credit score and that you have very good deal on financing from someone else (don’t tell them how much). If they offer financing below what you can get with the credit union, then take it. If not, be willing to walk away or tell them you’ll just pay with the credit union financing.
At this point a dealership is in a tough spot. You’ve already got a solid price on the vehicle. So they aren’t making money there. Now you don’t even need them for financing, an area where they hoped to make some money on the deal. Given the choice of not financing the loan (and making no profit from the deal) vs financing for very little, the dealership is likely to give you the great financing rate you want.
Have you ever paid cash for a nice, new car? If so, why? Given the choice, what would you do, pay cash or finance a new car?