A car loan can be a useful tool even if you have the cash savings to buy a car outright.
There are benefits to paying cash for a car – saving the interest and fees associated with a loan being the obvious one – but have you considered what else you could do with that money and if you would be better off long-term?
In this article, we will discuss how to compare your options so you can determine if you should get a car loan.
In This Post:
The Purpose of a Car Loan
A car loan is intended to spread out the upfront cost of the vehicle over time to make the purchase more attainable.
If you want to buy a $30,000 car then many will not have that sort of cash in their savings account.
It is a strange paradox that saving $30k sounds unattainable to many, but repaying that amount plus interest is the more trodden path.
Another way to think of a car loan is that it is forced savings, but you get the benefit upfront through the use of the car.
But you have to pay for that privilege!
Car Loans vs Paying in Cash
Cars are expensive to own no matter how you pay for them!
Your ongoing expenses will typically comprise of the following three categories:
- Car loan repayment
- Running costs (fuel, insurance, rego, maintenance, etc.)
- Depreciation
By paying cash upfront you can remove at least one of these categories.
But there is much more to consider that is situation-dependent.
We will share examples with numbers so you can decide if you should get a car loan or not, even if you have the money to purchase your car outright.
If the answer is yes, then click the button below to get in touch with the team at Gusto Finance. We can match you with the best lender for your situation and have you in your new wheels in no time!
Cost of Ownership
While it is a no-brainer that the cost of a car loan is going to be more than not having a car loan, it is worth at least quantifying the difference and what it means for your household budget.
Let’s look at an example where you need to borrow $30,000 for a new car at 9% interest. The loan also comes with $1,000 of associated fees.
Over a five-year repayment term, you will pay an additional $8,610 to borrow compared to paying in cash.
Opportunity Cost
Where things get more interesting is when you consider the alternative use of the $30,000 you have paid out of your own pocket to buy a car upfront.
What you sacrifice when you make that choice is known as the opportunity cost – but how often do people quantify this?
It will require some hypotheticals so bear with me! Let’s look at some alternative ways to use $30k.
- Leave the money in savings @ 5.4% interest (best rate at the time of writing).
- Pay $30k off your mortgage (assume a 5.88% interest rate) and 12 months into a 30-year $600k mortgage.
- Invest the $30k into a managed fund that averages a 9% return.
Now we have to consider the benefit to you of the above options compared to the cost of the car loan ($1,722 per year).
I have applied a 30% tax rate to the investment earnings (plus the medicare levy of course) so you can see the true benefit of each option. As you can see, the only inferior option is leaving your money in a savings account.
Note: these are examples only and your personal situation will vary.
| Use of Funds | Interest Rate | Annual Return/Savings | After Tax Benefit |
|---|---|---|---|
| Savings | 5.40% | $1,620 | $1,101 |
| Mortgage | 5.88% | -$1,764 | $1,764 |
| Managed Fund | 9.00% | $2,700 | $1,836 |
| Car Loan Cost | $1,722 |
The additional repayments to the mortgage create an interesting contrast to the other options. You don’t pay tax on money saved, but you do on money earned. So the interest saving benefit remains constant.
What the table does not consider is the compounding benefit of each option.
For example, over the remaining 29 years of the mortgage term, the one-off $30k repayment will save you $119,178 in interest!!
When compared to the $8k cost of the loan it is an easy choice.
Purchase Flexibility
When you are buying a car with cash your choice is limited by the amount of cash you have.
If a vehicle catches your eye that is above this you either have to negotiate hard, or take out a loan to close the gap.
Using auto finance as a tool in the negotiation can also help you secure a better deal on the vehicle which can offset some of the cost of the loan compared to when paying in cash upfront.
Asset Flexibility
When you take out a secured car loan the lender will register an interest against the asset.
There may be additional conditions you must satisfy to get the loan, including a requirement for comprehensive insurance (which you should have anyway!), but the biggest inconvenience comes if you wish to sell the car.
You will need the encumbrance removed before transferring the asset to another buyer.
This happens every day of course so it is manageable, but it is inconvenient to coordinate with the buyer and the lender.
Cash Flexibility
Any loss of flexibility with your car can be offset by the flexibility you gain with your cash!
Perhaps you want to keep a savings buffer to call on in case of emergency, or you enjoy investing are want to continue doing so.
Either way, hanging on to your savings and just making a monthly repayment can be of huge value to some which can outweigh the cost.
Pros and Cons of a Car Loan
In this section, we will summarise the comparisons made below into an easy-to-digest list of the advantages and disadvantages of each option.
Pros
- You can direct your money towards the greatest wealth-building option available to you.
- As you repay the loan your credit score will improve, opening up additional possibilities for your future.
- Freedom to choose how much of a deposit you put towards the car purchase which will determine your monthly repayment level.
- Your choice of car is not limited to your cash savings level. Perhaps you would like something more expensive and can close the gap with a car loan.
Cons
- It is more expensive. A car loan will incur fees and interest until repaid.
- You are tied to a regular repayment for the loan term which could become an issue if your circumstances change significantly.
- If you forget to make a repayment your credit score could be negatively impacted and your loan costs increase.
Pros and Cons of Buying a Car Outright
Pros
- Peace of mind – no matter what happens to your circumstances you do not owe anything for the car you drive.
- You save the cost of a car loan, which adds up to thousands of dollars over the years.
- You can sell the car without involving a third party of may have security over the vehicle.
Cons
- The opportunity cost of spending your savings as opposed to investing or repaying a mortgage can be far higher than the cost of a car loan.
- Saving enough money to buy a car outright takes a long time.
- Your choice of vehicle is limited to the amount of cash you have, and you have less leverage when negotiating with a car dealership.
Conclusion
You should get a car loan if you have a better use for your savings that will leave you better off in the long run.
Or, if you do not have enough savings to buy the car you really want and are able to support loan repayments comfortably.
If you are a risk-averse individual and you just don’t like owing money then buying your car outright will be the way to go.
If this is you then you are already a great saver, so buy the car and get back to replenishing that savings account.
But, if you think a car loan is the best option for you then get in touch today by submitting an online inquiry below.
