Buying a car is a big purchase no matter how you pay for it. Laura answers a listener's question about whether to spend cash for a car when you have it. Find out the upsides and downsides of financing or paying cash for your next vehicle.
Ryan S. says:
I'm looking into buying a car and have enough cash to pay for it. But someone mentioned that I should get a loan to get a lower price and just pay off the loan right away. They also said this could increase my credit score—is it true?
Thanks for your question, Ryan! Buying a vehicle is a big purchase, and I'm glad you're giving it careful consideration. This post will answer your question by reviewing the upsides of financing and paying cash for a car. Before spending your cash, it's critical to understand how it will affect your finances.
Before spending your cash, it's critical to understand how it will affect your finances.
Should you pay cash for a car?
It's terrific that Ryan has enough savings to pay for a car. But just because you have money in the bank doesn't mean spending it is the right move. First, let's review three advantages of paying cash for a car.
1. You avoid interest and financing charges
Paying cash means you save money by avoiding years of interest payments on an auto loan. Depending on your loan amount, interest rate, and term, your savings could be thousands of dollars.
2. You might buy a less expensive vehicle
If you only have a certain amount of cash to spend on a car, you'll have to stick to your budget. That can help you avoid overspending or getting talked into financing a higher-priced vehicle than you planned.
3. You avoid getting “upside-down”
The average new car depreciates about 20% within the first year you own it. That loss of value can be a big problem if you take out a loan and end up owing more than a car is worth, which is known as being upside-down. But when you pay cash for a vehicle, you'll always be able to pocket the full market value when you sell it or do a trade-in.
Some lenders won't finance vehicles purchased from private sellers, and those that do may charge higher interest rates.
Also, paying cash for certain cars may be your only option if they can't qualify for financing. That could apply to an older car, an antique, or a collectible car. Some lenders won't finance vehicles purchased from private sellers, and those that do may charge higher interest rates.
Should you get an auto loan?
While paying cash for a vehicle comes with advantages, here are three upsides of getting an auto loan.
1. You maintain your cash reserve
If paying cash for a car would leave you with no or too little emergency savings, it's a bad idea. Draining your bank account to buy a vehicle could leave you unprepared for an emergency, such as a loss of income or a high unexpected medical bill. Unless you would still have a healthy reserve left over, think twice about spending your cash on anything except a real emergency.
If paying cash for a car would leave you with no or too little emergency savings, it's a bad idea.
The right amount of emergency money is different for everyone, depending on your work and family situation. But a good rule of thumb is to accumulate at least 10% of your annual gross income as a cash reserve. For instance, if you earn $60,000, make a goal to maintain at least $6,000 in your emergency fund.
You might use another standard formula based on average monthly living expenses: Add up your essential costs, such as food, housing, insurance, and transportation, and multiply the total by a reasonable period, such as three to six months. For example, if your living expenses are $3,000 a month and you want a three-month reserve, you need a cash cushion of $9,000.
If you have zero savings, start with a small goal, such as saving 1% or 2% of your income each year. Or you could start with a tiny target like $500 and increase it each year until you have a healthy cash cushion. Don't worry that it might take years to accumulate enough, just get started now.
2. You might pay a lower purchase price
The advice Ryan received about using an auto loan to get a lower purchase price on a new car may be correct. Many dealers offer rebates when you finance a vehicle through their company because they make money on your loan, even when it's 0% APR.
Many dealers offer rebates when you finance a vehicle through their company because they make money on your loan, even when it's 0% APR.
So, if you're considering paying cash for a new car, ask the dealer for a side-by-side comparison of its financed versus cash cost. That will help you understand the potential savings and if doling out your cash is worth it.
As Ryan mentioned, if you take out a car loan with a dealer to qualify for purchase incentives, you can always pay it off early. Again, I don't recommend it unless you'd still have plenty of emergency money in the bank.
3. You can build credit
To build and maintain good credit, you must have credit accounts in your name and manage them wisely.
Ryan mentioned the possibility of an auto loan helping his credit, which is also true. To build and maintain good credit, you must have credit accounts in your name and manage them wisely.
Having a mix of credit accounts, such as revolving and installment loans, is one factor in your credit scores. That means taking out an auto loan can boost your credit if you make payments on time.
If you pay it off an auto loan after having it for only a month or two, you aren't likely to see much benefit to your credit.
Questions to ask before paying cash for a car
Before you spend cash on a vehicle, ask yourself the following questions:
- Would I still have enough emergency savings? Since the future is unpredictable, never raid your cash reserve without a valid reason. Without emergency money to fall back on, using credit cards and racking up debt could be the only way to manage a hardship.
- Am I saving for retirement? Before spending cash on a car, make sure you're saving regularly for retirement. The sooner you start, the better. Not only does starting sooner give you more time to contribute, but it puts the power of compounding interest on your side.
For example, if you contribute $500 a month for 35 years and have an average 8% return, you'd end up with more than $1.2 million to spend in retirement! But if you wait until ten years before retirement to start saving, you'd have to invest over $5,000 a month to accumulate $1 million.
A good rule of thumb is to invest at least 10% to 15% of your gross income for retirement. For instance, if you make $60,000, it's wise to contribute at least $6,000 per year to a tax-advantaged retirement account, such as an IRA or a retirement plan at work, such as a 401(k) or 403(b).
- Do I have high-interest debt? If you have expensive debt, such as credit cards or payday loans, paying them down could be a better use of excess cash than spending it on a vehicle. For instance, you'd come out ahead by paying down a credit card that charges 27% APR and getting a lower rate auto loan.
Ryan didn’t mention if he has a healthy emergency fund, is regularly saving for retirement, or has high-interest debt. But if his finances are in good shape, there’s nothing wrong with paying cash for a car. Nor is there a reason not to finance one to get a better price and then pay it off early. However, as I mentioned, that won’t help your credit as much as making payments as initially agreed.
If you’re considering using all or most of your cash cushion to buy a car, the takeaway is that it can make you vulnerable to potential financial hardship. Plus, plunking down cash may cause you to pay more for a car than financing it.