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Learn when to pay cash for a car or when taking out an auto loan is the better choice.
When you buy a car with cash, there are no future payment obligations. On the other hand, if you want to spend less cash as a down payment on a car purchase, you can finance the rest with an auto loan. But how’re you supposed to decide which route is best?
If you’re on the fence, don’t worry — we’ve outlined when it makes sense to pay all cash and when it’s wiser to take out a loan.
The Advantages of Financing a Car
Even if you have the funds to purchase a car outright, it’s still worth assessing your financing options. That’s because an auto loan could be the financially responsible decision, depending on a few conditions. Here are some advantages to financing a car.
Buy something you couldn’t otherwise afford
Debt typically carries a negative connotation, but this is the beauty of borrowing money. Loans enable you to purchase things that you couldn’t afford all at once. You’re essentially borrowing against your future income. So long as your monthly payments don’t prevent you from covering necessities and typical lifestyle expenses, using a loan to buy a car can be a viable option.
Secure low interest rates
When you take out a car loan, you’ll make regular payments to your lender. These payments consist of principal and interest, the latter of which represents the added cost of borrowing money versus paying in cash. If you’re able to secure a low interest rate, you can lower the overall cost of financing your car purchase.
Your interest rate will depend on several factors. For starters, your personal finances impact your rates, including your credit score, credit history, and income. Rates also vary by lender and lender type too. For instance, traditional financial institutions like banks and credit unions may offer lower interest rates compared to dealership financing programs.
However, depending on your credit, you may qualify for a dealership’s promotional offer, such as 0% financing for a certain number of months. In that case, you could space out your car payments interest-free.
This can be helpful when you apply for other types of debt in the future, such as credit cards or a mortgage. A history of timely payments can help you not only get approved for financing but also get the best terms.
The Disadvantages of Financing a Car
There’s no such thing as a free, no-strings-attached loan. Debt helps facilitate major purchases, but it’s still an obligation that carries risks. Let’s walk through a few disadvantages of financing a car.
Pay more in the long run
Perhaps the biggest disadvantage of financing a car versus paying with cash is the total cost. Loans aren’t free — in addition to principal repayments, you’ll also pay interest. Exactly how much you’ll pay depends on your loan amount, interest rate, and loan term.
For example, a 60-month, $15,000 car loan with a 5% interest rate will have $1,984 of total interest payments over the life of the loan. On the other hand, paying off a car immediately avoids this cost altogether. And if you’re not in a stellar financial situation (maybe due to bad credit), then your terms — and total cost — could be even worse.
Fortunately, refinancing is an option down the road. So, you aren’t locked into a high monthly payment for the entire duration of your loan. If you manage to increase your income or boost your credit, you might be able to refinance and get a lower interest rate. Last year, borrowers who refinanced saved almost $1,000 a year on average.
Less money to cover wants and needs
Financing a car is less of a financial hit at the time of your purchase. So, your liquidity remains intact. However, your car payments — which don’t even account for car insurance — could be a drain on your monthly income.
That means less money for other necessities like rent, utilities, and food. Less money set aside in a savings account. And less money available for general wants.
Potential to default on your loan
When you borrow money, there’s always the risk of not being able to repay your obligation. Loan defaults can significantly harm your credit score and remain on your credit reports for years. That may hurt your chances of qualifying for other loans later on.
It could even influence your ability to get a job or an apartment. Employers can’t see your score, but they can assess your credit history for financial distress. And landlords might look unfavorably at missed payments and loan defaults when evaluating your apartment application.
The Advantages of Paying Cash for a Car
They say cash is king. In terms of using cash to buy a car, that’s often true. Here are three advantages of avoiding debt and, instead, paying cash for your next car.
When you pay cash, you’re immediately off the hook. No loan necessary, no interest to pay. So, depending on your loan offers, you could save a lot of money by sidestepping a car loan.
Using our earlier example, you’d avoid a monthly car payment of $283 by paying for your car with cash. You could set some or all of this money aside for other life goals, such as investing for retirement or buying a house.
On top of that, some dealerships prefer all-cash transactions since they receive a lump sum upfront — they may even offer you rebates or discounts on the price of the car as an incentive.
Avoid going into debt
While debt isn’t inherently bad, steering clear of it could have a positive impact on your bank account and your psyche. Making monthly payments to an auto loan lender can take a toll on your income and could even become a source of stress if your finances are ever tight.
For instance, if you happen to lose your job or are unable to work, you won’t have to worry about repaying your obligations.
Own your car outright
Car loans are usually secured loans, meaning the vehicle serves as collateral. If you ever stop making payments, your lender might repossess the car. In that sense, you don’t really own your vehicle — not until you pay it off.
While you have an outstanding balance, you also could be at risk of going upside-down on your auto loan. This means your loan balance is higher than the value of the car, which isn’t uncommon because depreciation affects most vehicles. Being upside-down can become a problem if you ever need to sell your vehicle or if you’re in a major accident.
That’s why it’s often recommended to put 20% down when you buy a new car and 10% down when you buy a used car.
The Disadvantages of Paying Cash for a Car
Paying off your car right away can feel liberating, but it might not be in your best interests financially. Although you avoid debt this way, there are several drawbacks to using 100% cash.
Jeopardize your stability
The biggest disadvantage of paying cash for a car is the financial hit you take on day one.
That’s because cars aren’t cheap.
Of course, the price you pay depends on the cost of the car and whether it’s a used car or a new car. For instance, the average MSRP of a new vehicle was $45,000 in September. On the other hand, the average used car was $27,569 — an all-time high but still almost 40% cheaper than a new model.
Regardless, dishing out tens of thousands of dollars can drain your liquidity and potentially jeopardize your financial stability. Life is full of unexpected expenses and unfortunate career surprises, such as pay cuts and layoffs. If you don’t have adequate savings to cover the price of the car right now, it’s not worth the risk.
Might not be able to afford a reliable car
Affording a car is not the same as affording a reliable car with plenty of miles left under the hood. In other words, if you have long-term aspirations for your next vehicle, it’s probably better to go the financing route versus buying a clunker that’s on life support just to avoid debt.
Otherwise, you may wind up paying more in car repairs — or even funding a sooner-than-expected replacement.
Doesn’t build credit
When you pay cash for a car, you don’t have to worry about repaying a loan. While your monthly income remains intact, you don’t benefit from a credit perspective. That’s because income and cash purchases don’t show up on your credit report.
Taking out a sizable loan for the sole purpose of building good credit isn’t necessarily advisable, but it’s something to keep in mind if you’re on the fence.
Alternatives to Cash and Traditional Financing
You could decide to pay cash for a car. Or you might explore financing deals through conventional lenders or car dealers. But those aren’t the only two routes you can take. Consider these additional alternatives to ensure you make the right decision.
Whether you buy or lease a vehicle, you still get to drive it off the lot. It stays in your driveway or garage. And you can rely on it to get from point A to point B whenever you choose. However, there’s a big difference: leasing is like renting. You only get the car for a set amount of time — and often a limited number of miles each year.
On the flip side, you don’t have to worry about the selling process. No trade-in negotiations with a salesperson. No paying for ads or giving strangers test drives. Once your term ends, you simply hand the keys back over to the dealer.
This isn’t the only factor to evaluate though. For instance, warranty coverage is another key differentiator. Still, it can help you determine if leasing is even of interest in the first place. If you don’t want to drive one specific car for more than a few years, you may want to explore lease agreements.
Although peer-to-peer (P2P) lending is still a form of financing, it’s different in the sense that it cuts out financial intermediaries like banks and credit unions. Some P2P lending platforms have lower minimum credit thresholds. So, it can be easier to get approved for a personal loan, which you could use to fund your car purchase.
That said, it’s still important to be wary of fees and interest rates. Compare these platforms’ offerings to those of traditional lenders. That will help you make the most informed decision.
Should I Pay Cash for a Car or Finance It?
Like most financial decisions, choosing to pay cash or finance a vehicle is subjective. If you could narrow this decision to a single factor, it’s financial stability.
On one side, debt shouldn’t make it impossible to live your life or cause financial stress. You should be able to comfortably afford your car payments and auto insurance. Similarly, on the other side, a major cash purchase shouldn’t open the doors to unnecessary risk. You should have enough savings in an emergency fund before paying all cash for a vehicle.
Lastly, it doesn’t have to be a binary decision. You could take a hybrid approach through a sizable down payment. In other words, you could cover a significant percentage of the car’s purchase price upfront and fund the rest through a loan.