One question that I often get from clients is whether they should buy a new car with cash or finance it. When I’m faced with this decision, I like to look at the two alternatives from the perspective of their “cost” to me. Basically, when you take out a loan to purchase the car, you incur a cost in the form of interest. However, when you use all cash to purchase the car, there is also a cost - you forgo the opportunity to do something else with the money.
In today’s low interest environment, many car dealerships are offering financing at rates lower than 2%. For example, if you are offered an interest rate of 2% on your $25,000 car purchase – the “cost” of financing is the 2%. But by financing, you gain an opportunity to use the money as you wish during the life of the loan. If that opportunity is greater than the cost of 2% interest, then it makes more sense to finance the purchase; if the cost is greater than the opportunity, then it makes more sense to just pay with cash.
Let’s look at a few different scenarios.
- If your cash is sitting at the bank and you don’t anticipate using it for the next few years, your 2% cost is definitely greater than your opportunity of earning 0.10% at the bank. In this scenario, it’s probably better to just pay cash.
- However, even if your cash is at the bank not earning much, there may be situations where you consider taking out the loan anyway. For example, if your future income and/or expenses are uncertain over the next few years. I was in a similar situation when my husband and I purchased our first car. Even though there was a cost to financing, it was “worth it” in our minds to pay the interest because we can keep the cash on hand in case we need to dip into savings in the face of lower income.
- If instead, your cash is invested in the stock and bond markets, you have an opportunity to grow the $25,000 by greater than 2% per year over the life of the loan. In this case, you can also consider financing the car purchase and letting your money stay invested.
No matter what situation you’re in when it comes to purchasing a car, make sure that you can afford to part with the cash upfront or the monthly payments if you take out a loan, and factor in a margin of safety just in case unanticipated events happen over the next few years.