Many car buyers have some cash in the bank even though they are financing the purchase price of their new vehicle.
But would they be better off using some of this cash as a deposit for their car loan?
In this article, we will discuss the pros and cons of paying a deposit on that new car to reduce the size of your car loan so you can make an informed decision.
In This Post:
Choosing to Pay a Deposit on your Car Loan
In some cases, you may be required by the lender to pay a deposit as part of your loan settlement. We discuss these scenarios in more detail here.
However, in this post, we will be discussing those who have the option to pay a deposit and are not having this imposed on them by the lender.
Many borrowers would prefer to pay a deposit upfront to lower the amount they have to borrow.
The key questions to ask yourself are:
- Do you have a better use of the funds?
- How much financial risk are you prepared to take on?
If you consider these as you read through the points below you will be well placed to decide if you want to pay a deposit on your car loan or not.
7 Advantages of Paying a Car Loan Deposit
Reduce Interest Cost
The smaller your loan the less you will pay in interest over the loan term.
Most car loans are from 4 to 7 years and the interest cost can be significant over that period. Even a $1,000 upfront payment can save you a lot of money over that time.
Let’s look at an example with a $30,000 loan payable over 5 years, at 8% interest, compared to a $29,000 loan plus a $1,000 deposit.
The total interest payable over the loan term is below:
- $30,000 loan: $6,498 in interest
- $29,000 loan: $6,281 in interest
That is a saving of $217 over the life of the loan. A higher interest rate would lead to the savings being far more significant.
Lower Repayments
If we run with the above scenario, the repayments on the $29,000 loan are $20 a month lower for the full five-year term:
- $30,000 loan: $608
- $29,000 loan: $588
This can be helpful if you want to minimise the future strain on the household budget.
Increased Chance of Loan Approval
All lenders assess your income and living expenses in a different way, and also use buffers as a safety net to varying degrees.
So just because you know you can afford repayments doesn’t mean a lender will agree.
In the above scenario, a lender may determine you are a good credit risk, but the funds you have available to service the loan may only be $590 a month (in their view).
The deposit you are paying could be the difference in being approved for this loan or being declined.
Lower your Loan to Value Ratio
A car loan often allows you to capitalise the additional costs into the loan. These can include:
- Establishment fees
- Broker fees
- Insurance costs
- Warranty costs
So the day you drive away in your new car you will owe more than what the car is worth.
It takes time to pay down the balance and it is usually not until the second half of the loan term that your loan amount is less than the value of the vehicle.
By paying a deposit upfront you can pay all or some of these extra costs and be in a positive equity position much sooner.
Lower Your Risk of Negative Equity
After you account for establishment fees and costs, a no-deposit car loan will place you in a negative equity situation from day one (the loan is more than the car is worth).
This will not be a problem if you plan to keep your car long-term and maintain your payments without issue.
However, if your financial circumstances change and you need to sell the car you may be in a position where the sale price will not cover the amount payable.
Leaving you with no car, and additional payments to make.
Paying a deposit upfront will either remove this risk or shorten the timeframe of the negative equity position, depending on the size of your deposit.
Better Loan Terms
All of the above factors reduce the risk to the lender of giving you the loan if you pay a deposit.
Some lenders may view this favourably enough to influence the interest rate and maximum loan term available to you.
Paying a deposit could save you even more money than the discussed examples if it can secure you a lower rate or lower associated fees.
Purchase a Better Car
A combination of all of the above factors affecting the quality of the loan terms may increase your borrowing capacity.
On top of this, you also have funds to put towards the purchase which would get you to a higher maximum budget when it’s time to go shopping for your dream car!
3 Disadvantages of Paying a Deposit
You Have to Save
If you are applying for a new car loan then you should be able to save money – if you cannot, then perhaps the additional repayments that come with the loan is not a good idea.
The real cost here is time. If you need a car today then taking the time to save a deposit could be a negative for you.
You may be better off securing the car today and then working hard to pay down your new car loan.
Opportunity Cost of Funds
The interest rate on a car loan is anywhere from 6% all the way up to 28% (depending on many factors). Most people will be better off paying a car loan down as quickly as possible.
There are two scenarios where the opportunity cost of paying down the loan will leave you worse off:
- You have other debt with a higher interest rate – the additional funds should go towards that debt first.
- You are an investment genius and can generate returns higher than your car loan rate. Remember, you’ll also incur a tax bill for that return so you’ll need a return much higher than your car loan interest rate for this to be a better use of your money.
Depleted Cash Reserves
If you put all your savings towards a deposit then you may not have sufficient reserves to cover an unexpected bill.
You may be better off withholding your deposit and paying extra on your loan as your budget allows, while still having that safety net of emergency funds.
Conclusion
The benefits of paying a deposit on your car loan can grow exponentially with the size of the deposit.
For most people, it makes financial sense to do so. Unless you have a high-interest credit card, a payday loan, or any other expensive category of debt.
Speak to the brokers at Gusto Finance today so we can show you your loan options and how you can save money by using a deposit as part of your application.
